September 2010 FATCA: The Global Financial System Must...

Electronic copy available at: http://ssrn.com/abstract=1726093

Taxes—The Tax Magazine® 21

September 2010

©2010 D. Marsan

Dean Marsan was a first vice president and a senior tax counsel formerly with Lehman Brothers Inc. in New York City for the past 20 years. He was a participant on the American Bar Association Tax Section ad hoc committee for the “Com-ments on H.R. 3933 (H.R 3933, S. 1934) Foreign Account Tax Compliance Act of 2009 (FATCA),” which was submitted by the American Bar Association Tax Section on December 3, 2009, to the U.S. Senate Finance Committee and the House Ways and Means Committee and most recently a participant on the ABA Tax Section FATCA and 871(l) comment commit-tees and on the New York State Bar Association Tax Section ad hoc committee for its report on FATCA. He can be reached at [email protected].

FATCA: The Global Financial System Must Now Implement a New U.S. Reporting and Withholding System for Foreign Account Tax Compliance, Which Will Create Significant New Exposures—Managing This Risk (Part III)

By Dean Marsan

This article will be a separated into a three-part series that appears in the July, August and Sep-tember editions of TAXES—The Tax Magazine.

The article will address the new reporting and withhold-ing regime imposed upon foreign financial institutions and non–financial foreign entities, its impact on banks, insurance companies, multinational corporations and investment and mutual funds, as well the new reporting requirements for uncertain tax positions for U.S. and foreign corporations including life, property and casu-alty insurance companies and new tax compliance for individuals with foreign assets. In addition, the article will compare the qualified intermediary rules to the new rules for foreign financial institutions, changes to the tax treatment of substitute dividends and dividend equivalent payments received by foreign persons, the

repeal of certain foreign exceptions to the registered bond provisions, foreign trust provisions, IRS U.S. with-holding tax and information reporting examinations, liabilities for U.S. withholding tax, interest and penal-ties, U.S. account exposures, prophylactic planning and action steps, corporate governance and compli-ance to manage the U.S. account risk.

This third part of this article discusses a comparison to pre-FATCA U.S. withholding tax law; the impact of FATCA on audited financial statements and FIN 48/FAS 5 exposures; IRS audits of Tier I issues and the potential impact on financial institutions; reduction of FATCA/FDAP exposures—contractually outsourcing withholding and reporting responsibilities; product certifications of FATCA compliance; common types of withholdable payments; investor disclosure for FATCA; Treasury guidance on customer accounts, leg-acy accounts and systems; use of statistical sampling techniques to determine U.S. accounts, waivers for U.S. accounts and problems closing accounts; scope of the term “financial account”—U.S. brokers, swap dealers or nominees and DAP payments; investment fund FATCA issues, trusts—FATCA issues; reporting responsibilities—gross receipts and withdrawals; Treasury consolidated or separate FFI agreements; distinguishing between foreign financial institutions and non–financial foreign entities; comparison of the qualified intermediary rules to the new rules

Electronic copy available at: http://ssrn.com/abstract=1726093

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New U.S. Withholding System for Foreign Account Tax Compliance

for foreign financial institutions; pass-through pay-ment issues; audit considerations; exclusions of U.S. branches and agencies; clarification of whose treaty rights are waived if the FFI elects out of withholding responsibility; failure of NFFE to obtain information about substantial U.S. owners; FFI withholding, re-fund and treaty issues; the general FATCA provisions; confidentiality, effective date and grandfather rules; comments on the successful implementation of Chap-ter 4 and coordination with Chapter 3 and related prioritization issues; reporting of foreign financial assets and the definition of “specified foreign finan-cial asset”; the new PFIC reporting rules; electronic filing of certain information returns; abusive equity swaps; the Stop Tax Haven Abuse Act proposal to withhold on dividend equivalents; the 2010 Green Book proposal to prevent the avoidance of dividend withholding taxes; the tax treatment of substitute divi-dends and dividend equivalent payments received by foreign persons; the repeal of certain foreign excep-tions to the registered bond provisions; foreign trust provisions; IRS U.S. withholding tax and information reporting examinations; the IRS Industry Directive on total return swaps; liabilities for U.S. withholding tax, interest and penalties, including the new six-year statute of limitations, new penalties for failure to dis-close foreign financial assets and the new 40-percent accuracy related penalty for undisclosed foreign fi-nancial assets; U.S. account exposures, prophylactic planning and action steps; and corporate governance and compliance to manage the U.S. account risk.

[E]very stick crafted to beat on the head of a tax-payer will metamorphose sooner or later into a large green snake and bite the [IRS] commissioner on the hind part.

—Martin D. Ginsburg

Overview—Comparison to Pre-FATCA U.S. Withholding Tax LawAccording to one commentator:1

[T]he existing (that is pre-FATCA) withholding and reporting rules of [Code] Sec. 1441 (and the related qualified intermediary program ) are designed to ensure that the correct withholding and reporting occur on payments of U.S. source fixed and determinable annual or periodical

(FDAP) income based on the beneficial owner (U.S. or foreign) of that income. Thus, identify-ing the beneficial owner of that income is a key element of the current system. Problems with this system can arise, however, when U.S. investors limit their investments to foreign assets or make their investments through foreign entities that are the beneficial owners of the income.

Specifically, under the current rules, payments of foreign source income to U.S. persons outside the United States by non-U.S. payors (for example, payments to U.S. persons who invest in foreign markets through foreign banks [with offices outside the U.S.] are not subject to 1099 reporting. As a re-sult, the IRS has no record regarding some offshore investments of U.S. persons. The same issue arises when U.S. persons have made investments through foreign entities that, under U.S. tax principles are the beneficial owners of the income. For example, if U.S. persons invest in the U.S. markets through a foreign corporation or a foreign complex trust, the [Code] Sec. 1441 rules generally treat the corpo-ration or trust as the beneficial owner and do not require a U.S. withholding agent to look through to the identities of its owners.

By contrast if U.S. persons invest in the U.S. markets through a foreign partnership, the [Code] Sec.1441 rules look through the partnership to determine the beneficial ownership. Nevertheless, some U.S. investors in foreign partnerships have chosen to remain undisclosed to U.S. withhold-ing agents (that is, they have failed to provide documentation regarding their U.S. status to a foreign partnership or intermediary for submission upstream to the U.S. withholding agent). Although undocumented partners are subject to 30 percent withholding on their shares of the partnership’s U.S. source FDAP, such withholding may be at a lower rate than such persons would otherwise have been subject [and may be creditable in their local country of residence]. Further, gross proceeds from security sales currently are not subject to reporting and withholding (assuming the U.S. withholding agent does not have actual knowledge of the person’s U.S. status and the amount of proceeds allocable to such person.

Once effective [January 1, 2013], the newly en-acted withholding rules ([Code] Sec. 1471-1474),


September 2010

summarized below, will require U.S. withholding agents to impose 30 percent withholding on U.S. source FDAP and gross proceeds unless the foreign entity receiving the payment agrees to disclose specific U.S. persons to the IRS. The new regime seeks to accomplish its objectives, not by a system aimed at the beneficial owners of the U.S. source income, but rather by focusing on foreign entities investing in U.S. markets that fail to fully disclose U.S. persons who maintain accounts within the foreign entities or who have ownership interests in the foreign entities … the new rules also will require foreign partnerships to look through upper-tier foreign entities to identify the U.S. partners.

Will FATCA Work? There is some real concern that the withholding and reporting regime under FATCA while increasing the cost and stakes of the prior U.S. withholding system will not bring Americans into compliance. One group of commentators2 was more specific and stated:

On paper, [FATCA] seems like an effective way to encourage compliance by imposing a 40% negli-gence penalty. Practically speaking, however, the steep penalty may do little to encourage compli-ance and may discourage those taxpayers who have not yet made voluntary disclosure from do-ing so while the IRS has greatly publicized the fact that it had 17,000 formal voluntary disclosures by 10/15/09, as a practical matter that is a “mere drop in the bucket” compared to the amount of money still undeclared. Given that the U.S. vol-untary disclosure program penalty framework has expired and taxpayers are no longer guaranteed a certain result, many people who otherwise may have considered voluntary disclosure may now avoid compliance altogether, rather than run the risk of being subject to higher penalties.

See “Liability for Withholding Tax, Interest, Penal-ties and Statute of Limitations.”

Impact of FATCA on Audited Financial Statements FIN 48 Exposures

Many taxpayers are currently required by FASB In-terpretation No. 48, Accounting for Uncertainty in

Income Taxes (FIN 48) to identify and quantify un-certain tax positions in their tax return for financial statement purposes. Consider a foreign financial in-stitution or non–financial foreign entity who prepares U.S. audited financial statements and is subject to FIN 48. If after 2012, the foreign financial institution or non–financial foreign entity fails to comply with either the requirements under new Code Sec. 1471(b) or 1472(b), it is likely that these entities will have exposure to the IRS for any tax that should have been withheld under new Code Sec. 1471(a) or 1472(a) under the transferee liability rules under Code Sec. 6901 or in equity (e.g., unjust enrichment).

Thus, if a foreign financial institution or non–finan-cial foreign entity failed to comply for a number of years, the withholdable payments that were received by such entities presumably could be grossed up by the Treasury for the unpaid 30-percent U.S. with-holding tax, together with interest and penalties. It is not inconceivable that the combined impact of the liability may exceed the balance in the U.S. accounts, and in some egregious cases may cause the entity to file bankruptcy unless the IRS agrees in the closing agreement to favorable payment terms (e.g., install-ment payments over a number of years to satisfy the deficiency, interest and penalties).3 In any event, for financial statement reporting purposes it is likely that this exposure will have to be reflected as a FIN 48 tax reserve and may in fact require the restatement of earlier financial statements if material.

FAS 5 ExposuresFinancial Accounting Standards Statement Number 5 (FAS 5), Accounting for Contingencies, was issued over 30 years ago by the Financial Accounting Stan-dards Board (FASB). After 2012, withholding agents and payors (including foreign financial institutions that are withholding agents or payors responsible for with-holding on withholdable payments to noncompliant foreign financial institutions or non–financial foreign entities under new Code Sec. 1471(a) or 1472(a) or on pass-through payments to recalcitrant account holders and non-participating foreign financial institutions under new Code Sec. 1471(b)(1)(D) or 1471(d)(3)) will be personally liable for the tax required to be withheld as well as interest and penalties.

Based on history, it is not an understatement to say that many withholding and transaction taxes may be overlooked. However, given the potential huge finan-cial exposure of a withholding agent or payor who fails to withhold under FATCA, it can be expected

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that firms who have annual audits of their financial statements will now be under increased scrutiny by their auditors to ensure the FAS 5 reserves relating to FATCA withholding (and Chapter 3 withholding taxes) are reported properly on their financial state-ments. To that end, firms should ensure all FATCA and Chapter 3 taxes required by FAS 5 are accrued for and fully documented and that withholding procedures and manuals are updated for the new withholding regime as soon as guidance is provided by the IRS on FATCA.

Alvarez provided the following excellent analysis for FAS 5 as it relates to sales and use taxes,4 which may be useful in the U.S. withholding tax area:

Background. It is important to understand the definition of a contingency. In March 1975, the FASB issued FAS 5, outlining the appropriate ac-counting for contingencies. Paragraph 1 defines a contingency as “an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur.”

Examples of loss contingencies include pend-ing litigation and actual or possible claims and assessments. Risk detection should not be con-sidered in reporting loss contingencies regarding taxes. For example, the likelihood of being caught if a company does not comply with the law (i.e., does not file a return, does not collect the tax) is not a valid reason for not recording the liability. In addition, if an assessment is pending, the tax practitioner must assume all the evidence will be reviewed by the examiner when determining the likelihood of the outcome. Next, it is important to know what contingencies need to be disclosed. Paragraph 8 of FAS 5 states “an estimated loss from a loss contingency shall be accrued by a charge to income if both of the following condi-tions are met: (a) information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred” and “(b) the amount of the loss can be reasonably estimated.” Prob-able is defined in paragraph 3 as “the future event or events are likely to occur.”

If one or both of these conditions are not met related to a contingency, disclosure of the con-

tingency must be made when there is at least a reasonable possibility that a loss or an additional loss may have been incurred. The disclosure must indicate the nature of the contingency and estimate the possible loss or state that such an estimate cannot be made (paragraph 10). “Rea-sonably possible” is defined in paragraph 3 as “the chance of the future event or events occur-ring is more than remote but less than likely.”

Once it has been determined that a contingency exists and that it must be disclosed, the contin-gency must be estimated. FASB Interpretation No. 14 (FIN 14) provides an interpretation of FAS 5 on how to provide for a reasonable estimation of the amount of a loss. But although guidance is provided on pending litigations and the use of ranges to estimate the liability, FASB does not provide substantial guidance on methods that may be used to calculate the contingency. Once you have determined that a contingency exists, you must determine whether the contingency may be reasonably estimated. Unfortunately, FAS 5 provides minimal guidance as to what is reasonable. Merriam-Webster’s dictionary de-fines reasonable as “being within the bounds of reason.” Since sales and use taxes are transaction based, quantifying any of the above-mentioned potential contingencies could require reviewing large amounts of data even to calculate an esti-mated amount of liability or a range of liability.

There are several factors to consider when quan-tifying a FAS 5 contingency:

Customer obligations/indemnifications—When quantifying your exposure, consider customer obligations. For example, your company may have failed to collect sales and use taxes, some-thing that could result in the need for an accrual. However, contact your customer to see if they have already self assessed and paid the tax, paid the tax as a result of a tax assessment, should have issued a resale or exemption certificate, or would be willing to be invoiced for the tax. If so, and assuming it can be reasonably estimated, your exposure should be modified to take this into account [There is no analogous principle under FATCA—the fact that the payee has paid the withholding tax does not alleviate the with-holding agent or payor from its own responsibility


September 2010

to withhold under new Code Sec.s 1471(a) and 1472(a).5]

In addition, review all agreements related to recent acquisitions to verify which party will be responsible for any taxes due associated with an acquisition. The agreement may also contain an indemnification clause that could relieve your company from all or part of the liability, and this could affect your estimated contingency.

Contingency estimate by state or legal entity—If you plan to perform a sample or use an alter-native method to estimate the contingency, be prepared to identify the amount of the exposure by state, by legal entity and by period. This will be necessary to properly account for the accrual in the financial statements and to update the ac-crual periodically. In addition, if a sample period is selected to estimate the exposure related to non-taxed purchases, consider using total ac-counts payable data to apply to the error rate to calculate the exposure. [At present there are no provisions for FATCA that permit use of a sample or other acceptable methods to estimate the withholding tax liability under new Code Secs. 1471(a) and 1472(a) although the IRS has used statistical sampling techniques in it 1441 audits for several years.]

Penalties and interest—Most states impose penalties and/or interest associated with an as-sessment; therefore, these additional costs should be included when calculating an estimated con-tingency. However, several factors could occur that would not require including penalties and interest. For example, if the liability is associated with failure to collect the tax in a particular state, and if the company may participate in a voluntary disclosure program or an amnesty program that may provide for full or partial waiver of penalties and/or interest, perhaps no additional liability need be included.

Review by the external auditors—Bottom line, make sure you have proper documentation on file to support your accrual. It may be several months before the auditors will review your documentation. The schedules should speak for themselves and not require any explanation. If you performed a sample, make sure you have

documented the methods you used to design and select your sample, as well as any assumptions made. Understand how the external auditors plan to audit the accrual you have calculated. Most au-ditors have experience doing samples; however, if they plan to test your sample, make sure you understand how they plan to project their results in case they find any errors.” [The Treasury has not yet put out guidance on the documentation or account verification procedures it will require to support a withholding agent’s accrual.]

Because FATCA issues are likely be material and significant (e.g., withholding on gross proceeds from the disposition of U.S. stock or securities) when they arise as a result of failing to withhold a 30-percent tax under new Code Sec. 1471(a) or 1472(a) for withholdable payments made to a foreign financial institution or non–financial foreign entity, respec-tively, or from the failure to withhold a 30-percent tax on pass-through payments to recalcitrant account holders or non-participating foreign financial institu-tions under new Code Sec. 1471(b)(1)(d) or 1471(d)(3), it is likely that a financial statement reserve issue may arise either on the basis of FAS 5 or FIN 48.

In many cases, it is likely the withholding agent, the foreign financial institution, the non–financial foreign entity or the intermediaries in the payment and reporting chain may end up in litigation if the Treasury finds a Chapter 4 deficiency, interest and penalties. This exposure may arise by contract (e.g., an indemnity by a servicer or administrator or a third party who has undertaken the FATCA withholding or reporting responsibilities) or as a result of their posi-tion as a fiduciary (e.g., manager or sponsor), or in equity on a transferee liability theory among others.6 Thus, a firm will have to contend with how to ac-count for what may be very material and significant loss contingencies on their financial statements as well as what parameters (e.g., indemnities, insurance, etc.) must be considered to mitigate the amount of the reserve or its reversal.

Perkins Cole7 has put together the following cogent analysis which goes into an analysis of FAS 5 that may be helpful:

Determining when and how to account for loss contingencies is an important decision for com-panies that have been sued. Reserving funds for possible litigation losses may significantly affect reported earnings. Worse, failing to book appropri-

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ate reserves may lead to restatements of earnings, which could invite an SEC investigation or share-holder litigation. Apart from reserves, the mere decision whether to disclose pending litigation in financial statements can also have major financial and legal ramifications. Moreover, both public and nonpublic companies are affected because both must properly account for and disclose litigation loss contingencies to comply with Generally Ac-cepted Accounting Principles (“GAAP”).

Unfortunately, setting loss reserves is not as easy as following simple steps or plugging numbers into a formula. The accounting standards are muddled and applying them requires a great deal of discretion and judgment. Even the disclosure rules are fraught with peril.

When Is a Litigation Loss Reserve Required?

Under Financial Accounting Standard No. 5 (“FAS 5”), a company must create a litigation loss reserve if (1) a loss is probable and (2) the amount of the expected loss is material and reasonably estimable.

(1) Is a Litigation Loss “Probable”?

The first challenge is to figure out when a loss is “probable.” FAS 5 identifies three categories of likelihood: “probable,” “reasonably possible” and “remote.”

Probable. According to FAS 5, a future event is “probable” if it is “likely to occur.” FAS 5 does not define “likely,” except to say that “probable” does not infer “virtual certainty.” Formal defini-tions aside, “probable” is usually interpreted in practice as meaning “highly likely.”

In evaluating the probability of an unfavorable litigation outcome, factors to consider include: (a) the nature of the litigation, claim or assess-ment; (b) the progress of the case; (c) the opinions of legal counsel and other advisers; (d) the ex-perience of the company and others in similar cases; and (e) any deci sion by management as to how the company will respond to the lawsuit. Deter mining whether a loss is probable requires consider able judgment, and the assessment may change as the litigation progresses.

Reasonably Possible. If the “chance of the future event or events occurring is more than remote but less than likely,” the adverse out-come is deemed “reasonably possible.” A loss reserve is not required, but disclosure may be (see below).

Remote. If the chance of an adverse outcome is slight, the event considered is “remote,” and that ends the analysis. No reserve or financial statement disclosure is required. Periodic re-assessments of pending and threatened litigation may be necessary, however, to determine whether a loss that once seemed remote is now probable or reasonably possible.

(2) If a Loss Is Probable, Is the Amount of the Loss Reasonably Estimable?

If a company determines that a loss is probable, it next must consider whether the amount of the loss will be material and if it can be estimated. If the loss is not material or cannot be reasonably estimated, no reserve is required. Even if it is impossible to estimate the exact amount of prob-able loss, however, a company should attempt to estimate the range of possible losses. If no amount within the range appears to be the best estimate, the company should reserve the low end of the range and then dis close the remaining amount, up to the high end of the range, as a “reasonably possible” loss.

When Is Disclosure Required?

If a company determines that a loss is only “rea-sonably possible” or that a loss is “probable,” but the amount is not reasonably estimable, the company need not establish a reserve, but it still must disclose the nature of the possible loss and give an estimate of the possible loss or range of loss. The key is to ensure that the financial state-ments are not misleading.

In addition to the disclosure requirements of FAS 5, public companies must also disclose signifi-cant legal proceedings under SEC Regulation S-K Item 103, which requires disclosure of material legal proceedings in both the annual report (on Form 10-K) and the quarterly report (on Form 10-Q), unless the claims represent less than 10


September 2010

percent of the company’s current assets. SEC Reg. § 229.103. Thus, in some instances Regulation S-K may require disclosure of pending litigation that need not be disclosed under FAS 5. [Chart 1] illustrates the decision process[.]

Practical Tips

Companies that either fail to es-tablish sufficient litigation loss reserves or overstate litigation loss reserves (so that the company can “manage earnings” by releasing reserves into income in bad years) have faced private litigation and SEC enforcement actions. The following tips may help avoid com-mon pitfalls.

Tip 1: Establish a company reserve policy and apply it consistently. A written and consistently applied reserve policy may help a company defend a decision not to book a reserve. Establishing and following the policy helps the company avoid appearing opportunistic in setting and maintain-ing reserves.

Tip 2: Err on the side of disclosure where there is any chance that a litigation loss could be considered “reasonably possible.” Failing to disclose the possibility of a material litigation loss can result in lawsuits and enforcement ac-tions if it later becomes clear that reserves were inadequate and company executives knew or should have known that a material loss was reasonably possible.

Tip 3: Book a reserve only where a loss is prob-able and the amount of loss can be reasonably estimated. A reserve should not be booked unless both FAS 5 requirements are satisfied. The SEC views creation of reserves for an improbable amount of loss to be a form of earnings man-agement. If a loss is only reasonably possible, the company should disclose the nature of the contingency and an estimate of the possible loss or range of loss (or state that such an estimate cannot be made).

Tip 4: Reverse a reserve only where a change in facts makes the reserve (or a portion of the reserve) unnecessary. The SEC looks unfavorably on a company’s release of reserves into income where no specific development or change justifies the release. Reversing a reserve in a bad year is particularly likely to be viewed as opportunistic.

Tip 5: Do not create general reserves to cover unspecified claims. Litigation reserves should be determined on a case-by-case basis and should not be created for general future litigation costs and expenses.

Tip 6: Periodically reassess pending and threat-ened litigation to determine the adequacy of reserves. The probability of a loss and the abil-ity to estimate the amount of the loss will likely change as the litigation progresses. A litigation loss considered remote when the suit was filed may later become reasonably possible or prob-able if dispositive motions are unsuccessful or discovery reveals damaging facts. It is also impor-tant to reassess the amount of existing reserves. If the underlying case settles, for example, the reserves must be reversed into income.

Chart 1

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IRS Audits of Tier I Issues and the Potential Impact upon Financial InstitutionsIRS realigns and renames Large Business Division and enhances the focus on international tax admin-istration. On August 4, 2010, in IR-2010-0888 (the “Notice”), the IRS announced as part of a continuing effort to improve global tax administration efforts, the realignment of the Large and Mid-Size Business (LMSB) division to create a more centralized orga-nization dedicated to improving international tax compliance. As part of the organizational shift, the name of the IRS’s large corporate unit—LMSB—will change on October 1, 2010, to the Large Business and International (LB&I) division.

As part of the notice, IRS Commissioner Doug Shul-man stated: “Executing our international strategy is a top priority, and our work continues to intensify in this area, Every day, we are moving forward in our international compliance efforts. Bringing together our top international personnel in this new group will help us advance our global tax administration efforts and ensure focus and fairness in a critical area for our nation.”

The Notice indicates the new LB&I organization will enhance the current International program, add-ing about 875 employees to the existing staff of nearly 600. Most of the additional examiners, economists and technical staff are current employees who spe-cialize on international issues within other parts of LMSB. The realignment will strengthen international tax compliance for individuals and corporations in several ways, including identifying emerging inter-national compliance issues more quickly, removing geographic barriers, allowing for the dedication of IRS experts to the most pressing international issues, increasing international specialization among IRS staff by creating economies of scale and improving IRS international coordination, ensuring the right compliance resources are allocated to the right cases, consolidating oversight of international information reporting and implementing new programs, such as the FATCA, coordinating the Competent Authority more closely with field staff that originate cases, especially those dealing with transfer pricing and otherwise centralizing and enhancing the IRS’s focus on transfer pricing.

Heather C. Maloy will continue serving as Com-missioner of LB&I. Michael Danilack, Deputy Commissioner, International, will head the realigned

global unit. Paul D. DeNard will continue serving as Deputy Commissioner (Operations). The new international unit will include a transfer pricing di-rector, who will continue piloting the new transfer pricing practice, and a chief economist, who will oversee the IRS’s economic positions pertaining to transfer pricing.

“The realigned organization will let us focus on high-risk international compliance issues and handle these cases with greater consistency and efficiency as we continue to increase our work in this area,” Shulman said.

In addition, the realigned LB&I will continue to serve the same population of taxpayers—corpora-tions, Subchapter S corporations and partnerships with assets greater than $10 million as well as certain high wealth individuals. The Notice further indicates that the announcement marks the latest in a number of efforts the IRS has made to increase in-ternational tax compliance. The IRS has taken major steps to address offshore tax evasion, including the investigation of the misuse of undisclosed offshore accounts by U.S. taxpayers. Last fall, the IRS created a Global High Wealth Industry unit to better monitor tax compliance by high income individuals and their related enterprises.

The Notice indicates that LB&I is also charged with overseeing the implementation of FATCA, which will substantially improve international information reporting, increasing international transparency and compliance, and notes the IRS and the Treasury have also worked to revise tax treaties and tax information exchange agreements (TIEAs) to increase transpar-ency and to make it more difficult for taxpayers to evade taxes just by crossing international borders.

IRS “Rules of Engagement.” In 2007, the IRS issued its so-called Rules of Engagement for examinations under which examining agents will have certain ranges of discretion in applying guidance to a tax-payer’s facts and circumstances with respect to issues deemed to pose the greatest compliance risk.9 The Rules of Engagement classify issues into three cat-egories: (i) Tier I, issues of high strategic importance; (ii) Tier II, issues of significant compliance risk; and (iii) Tier III, issues of industry importance.

Tier I issues are those that have significant impact on one or more industries and include areas involving a large number of taxpayers, significant dollar risk, substantial compliance risk or high visibility where there are established legal positions and/or large- or medium-size business division (LMSB) direction. Tier


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II issues reflect areas of potential high noncompliance risk to LMSB or an industry and includes areas where the law is fairly well established, but there is a need for further development, clarification, direction and guidance on LMSB’s position. Tier III issues are those issues that represent the highest compliance risk for a particular industry and which require unique treat-ment for an industry.10

Code Sec. 1441 reporting and withholding of U.S. source FDAP income made a Tier I issue. On March 18, 2009, the IRS stepped up its enforcement effort to enforce cross-border compliance by announcing that cross border withholding would be treated as a Tier 1 issue (“U.S. Withholding Agents—Code Sec. 1441 Reporting and Withholding on U.S. Source FDAP Income”).11 In a separate document, the IRS explained its rationale for designating U.S. source FDAP income as a Tier I issue by stating the “potential use of total return swaps to minimize withholding tax.”12

On June 17, 2010, Michael Danilack, Deputy Commissioner (International), at the 22nd Annual Forum on International Tax and Withholding and Information Reporting Conference presented by EEi, explained that while the FATCA legislation has an effective date on December 31, 2012, the IRS is not going to relax its efforts to enforce the existing U.S. withholding tax laws under Chapter 3 for QIs and non-QIs and under Code Sec. 1461 which addresses withholding agent liability.

Thus, it can be anticipated withholding agents at major financial institutions will likely be subject to a so-called Tier I audit during the next 30 months prior to the effective date of FATCA which will not only cre-ate tax exposures for these institutions, but will give the IRS a pretty good idea of those institutions who may not be willing to become fully compliant with FATCA, either as a withholding agent or as a foreign financial institution or non–financial foreign entity. In addition, once IRS agents become thoroughly fa-miliar with U.S. information reporting audits under Code Sec. 1461, it will be easier for the IRS to train its examiners on how to conduct an audit to enforce the FATCA rules.

Code Sec. 1461 audits. It can be expected that IDRs13 will be forthcoming which will analyze the methods, operating manuals, checklists, procedures, processes and systems and internal audit reports used by U.S. withholding agents to process new accounts, including identification of the payee, fiduciary op-erations, customer account opening and validation procedures and processes for recording customer

transactions. In addition, the IDRs will likely ask for flowcharts, diagrams and other material that describes how customer account information is incorporated into each company’s EDP system for, among other things withholding and tax reporting purposes. The names and titles of all individuals familiar with the withholding and reporting systems and manuals and procedures will likely also be requested.

Importantly, the IDRs will likely also request cus-tomer ledgers or other records pertaining to each entity’s U.S. withholding and information reporting that record, report, identity or show information about customers who have been classified as foreign residents for withholding and reporting purposes and may also include a request for e-mail and other computer and manual records.

As an integral part of the withholding examination, the examiner will likely review the W-9s, W-8BENs, W-8ECIs, W-8EXPs and W-8IMYs.

Among other areas, the IRS examiner will review the U.S. withholding agent’s systems to determine whether it considers the following: (i) beneficial owner processing, (ii) exempt entity processing, (iii) “no documentation” requirements process-ing, (iv) processing for intermediaries, (v) interest withholding and exemptions, (vi) securitized trans-actions, (viii) REIT processing, (ix) original issue discount, (x) eligible securities, (xi) U.S. branch processing, (xii) affiliate transactions, (xiii) inter-national organizations, (xiv) exempt recipients, and (xv) backup withholding.

As part of this exam, the IRS will review the ac-count opening procedures and examine how the identity of each payee is established upon entry into the bank/brokerage/insurance/custodial account system. Among other questions, the IRS will seek to know whether the U.S. withholding agent properly identifies appropriate account withholding treatment, whether it ensures the proper separation of duties with respect to opening and processing of accounts as part of the internal control description (e.g., employees whose duties include opening accounts are not part of the retention, custody, or accounting for records) and how exceptions by the firm are addressed.

As part of the IDRs, the IRS will likely ask for a copy of all Forms 1042, Annual Withholding Tax for U.S. Source Income of Foreign Persons filed for all the open tax years and a copy of the Form 1042-S, Foreign Person’s US. Source Income Subject to With-holding for each entity in the consolidated group and any workpapers or other supporting documents

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used in preparing these documents, and if complete forms are not available, the (i) name of each payor, (ii) name of each payee, (iii) the country in which the payee is located, (iv) the amount paid (v) the dates of payment, (vi) the type of payment, (vii) the amount withheld and rate withheld, and (viii) any applicable treaty reductions.

After this information is obtained, it is likely the IRS will apply statistical sampling techniques to examine the accounts. To this end, the examiner may group the transactions into strata according to dollar value or other areas of interest or concern including but not limited to (i) accounts grouped by withholding rate, (ii) accounts grouped by amount, (iii) account grouped by the recipient’s country from Form 1042-S, (iv) amounts grouped by the recipient’s code from 1042-S, (v) accounts grouped by the expected docu-mentation to be reviewed such as W-8IMY, W-8BEN and W-8EXP, (vi) accounts grouped by business unit, product, platform, legal entity or cost center, and (vii) accounts grouped by margin account, sweep account, and other specialized depository, custodial and escrow accounts.

Presumably, a Computer Audit Specialist will be brought with the assistance of the Statistical Sampling Coordinator to determine the appropriate sample size and the validity of the sample. In most cases, the sample size will be at least 100 accounts excluding all the strata tested on a 100-percent basis to support the use of the ratio and regression estimators.

Once the sample is identified the examiner will request the account file and documentation informa-tion from the U.S. withholding agent for each account selected. In addition to the information identified above, to see if the payee provided the appropriate documentation, the verification of the payee status and classification as foreign status, the examiner will consider the type and source of income in determin-ing if the withholding is correct. Among other types and sources of income the examiner will look at (i) securities lending, (ii) interest paid by U.S. obligors, (iii) the sale of property and assumption of bonds, (iv) margin accounts, (v) interest coupons in default, (vi) domestic corporations paying to foreign affiliates, (v) original issue discount, (vi) bank deposit interest, (vii) portfolio interest, (viii) interest and real property mortgages, (ix) interest paid to controlled foreign corporations, (x) notional principal contract income, (xi) dividends, (xii) eligible securities, (xiii) effectively connected income, (xiv) U.S. branches, (xv) REIT distributions, and (xvi) international organizations.

Pre-2013—U.S. withholding and reporting audits of syndicated loans—Code Sec. 1441. As a Tier I issue, the IRS will be particularly interested in how a financial institution which is a withholding agent complied with the U.S. withholding and reporting law for its syndicated loans. A syndicated loan results when financial institutions collectively participate in funding a single loan. Generally, one of the par-ticipants will act as an administrator and distribute the interest income to the other participants. The administrator will be the withholding agent.

Code Secs. 871(h) and 881(c) generally provide that a non-U.S. person is exempt from the 30-percent withholding tax on portfolio interest. There are several limitations on this exemption such as the “bank loan exception.” The portfolio exemption does not apply to any interest received by a bank on the extension of credit made pursuant to a loan agreement entered into in the ordinary course of its trade or business.14 Accordingly, foreign banks, which are participants in the syndicated loan, should not benefit from the portfolio exemption.

Often the participants will change. For example, when the original participants sell all or a portion of their interests in the loan to another bank, withhold-ing related documentation is required from each of the new participants. An audit concern is to deter-mine if required Forms 1042 and 1042-S were not filed and/or Forms W-8 were not secured.15

2013 and Forward—U.S. withholding and report-ing audits of syndicated loans—Code Secs. 1441 and 1471–1474. The IRS will likely continue examining and putting resources toward examining syndicated loan and other structures at major financial institu-tions as a Tier I issue to ascertain if the financial institutions are complying with FATCA under new Code Secs. 1471–1474, as well as under Code Sec. 1441 and the FDAP rules.

Since merger and acquisition deal making is cur-rently anemic with only a smattering of multi-billion dollar deals in 2010, the market activity for syndi-cated loans has been severely curtailed. However, as the economy begins to improve next year, it is likely that many undervalued and vulnerable companies will become targets by both private equity and strate-gics alike. Presumably, this will again create a buyers’ market and demand for these companies and also a heavy demand on the debt markets.

However, many bank balance sheets are currently “risk constrained.” That is, because of the lessons learned from the recession, unless a major bank is


September 2010

meaningfully involved, knows the company well for many years, its strengths and weaknesses and its credit and liquidity it will not fund the entire loan itself. This is likely true even for the biggest banks with the horse power of huge balance sheets—they will undoubtedly seek the lower risk of a syndicated loan with other mid- and smaller sized banks, funds and private equity investors to partner up with as part of a loan consor-tium to reduce their risk in any one deal.

For U.S. tax purposes, each mega deal may now create huge tax exposure that in the past was not present (e.g., FATCA 30-percent withholding tax is not only based on FDAP income, but is also applied on the gross proceeds from the sale or disposition of U.S. stock or securities received by a noncompli-ant FFI/NFFE) unless these deals are properly vetted for both FATCA and FDAP reporting and withhold-ing purposes. To that end, the term sheet and other loan documentation should be reviewed before the deal goes hard to ascertain who are the withholding agents in the syndicated loan structure for purposes of the two regimes, and who is responsible for the U.S. withholding and reporting. Since there may be more than one withholding agent responsible, the deal documents should by contract spell out the re-sponsibilities and obligations of each of the lenders, borrowers and their intermediaries or their agents and other professionals.

Under both withholding tax regimes, it is critical to ascertain whether the U.S. borrower has obtained a loan directly from a lead bank that has then gone out and obtained separate loans from other partici-pant banks and lenders, or whether the borrower has entered into a loan directly with a loan syndication group including the lead bank. It may prudent to obtain an opinion from outside counsel as to whether the lead bank has provided one large mega loan for a buyer in an M&A deal (or its holdco) or whether the syndication loan group has provided the funding based upon each participants share of the aggregate debt as individual debt holders.

Thus, if IBM in its capacity as a borrower goes to a U.S. bank (or to a foreign bank’s office in the United States) and obtains a large loan to facilitate its acquisi-tion of a strategic target, the financing will likely by treated by the IRS as a loan between the equivalent of two U.S. persons (assuming the foreign bank’s U.S. branch is excluded from FATCA when the IRS pro-vides guidance) for withholding tax purposes and not subject the payments under the loan to withholding taxes under either the FATCA or the FDAP rules.

However, if that same bank then goes and obtains financing for this loan by obtaining various loans from foreign banks, offshore funds and other foreign entities which may have U.S. accounts, it is possible for the lead bank (or its agents and administrators) to be treated as withholding agents for FATCA, as well as for purposes of Code Sec. 1441 (Note: FDAP withholding may be triggered if an exemption does not otherwise apply even if these foreign entities do not have U.S. accounts).

As the withholding agent, the lead bank will likely have to obtain Forms W-8 (or equivalent for FATCA) that its subordinate lenders are compliant FFIs or NFFEs and to determine whether it (or its administra-tor) must withhold and report under Code Sec. 1441. If the foreign subordinate lenders to the lead bank are not compliant FFIs or NFFEs, it is likely the lead bank will be required to withhold under new Code Sec. 1471(a) or 1472(a). Similarly, if the portfolio exemption does not apply because the one or more of the loans was made by subordinate lenders in the ordinary course of its business, another exemption does not otherwise apply or U.S. treaty relief is not available to reduce the rate of withholding it is likely the lead bank will have to withhold a 30-percent tax and report under Code Sec. 1441 the interest paid to the foreign subordinate lenders.

It should be noted if FATCA withholding applies in the first instance to withholdable payments (FDAP and gross proceeds from the sale or disposition of the loan) made by lead bank to the foreign subordi-nate lenders, there will not be a second obligation to withhold by the lead bank under Code Sec. 1441 for the FDAP income on the loans. However, if the foreign subordinate lenders are compliant FFIs or NFFEs, it is very possible that the lead bank may have an obligation to withhold on the FDAP income (e.g., interest income) if an exemption does not otherwise.

On the other hand, if IBM in its capacity as a bor-rower entered into a loan with a group of banks, offshore funds and other foreign entities, it is likely IBM (or its custodian or agent) will be the with-holding agent responsible for obtaining directly from these lenders Forms W-8 (or its equivalent for FATCA) to ensure that they are compliant FFIs or NFFEs. Here again, IBM will have the obligation to withhold on any withholdable payments received by noncompliant FFIs or NFFEs. If these lenders are otherwise found to be compliant for FATCA purposes, IBM may have an obligation to withhold

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on any FDAP income if an exemption does not otherwise apply.

It is possible that the lead bank or other intermediar-ies or agents that helped arrange the consortium may also be viewed as a withholding agents for FATCA and FDAP purposes in addition to IBM unless the underly-ing facts and documentation support the position that the lead bank or others were not acting as persons having control, receipt, custody, disposal or payment of any such payment in whatever capacity.16

Reduction of FATCA/FDAP Exposures: Contractually Outsourcing Withholding or Reporting Duties, Product Certifications of FATCA Compliance—Preliminary ThoughtsAs the IRS provides guidance on how to implement the new legislation it may be prudent for foreign financial institutions, non–financial foreign enti-ties, withholding agents, intermediaries, servicers, managers, sponsors and other third-party vendors who decide to outsource the reporting or withhold-ing duties (including withholding on pass-through payments to recalcitrant account holders or nonpar-ticipating foreign financial institutions) to consider the possible increased FAS 5 or FIN 48 exposure to ultimately resolve the private litigation that may arise in the case of noncompliance under FATCA or the FDAP rules and possible mitigants that may reduce the FATCA/FDAP exposures and permit an adjustment or reversal of these reserves.

It is likely that some firms or offshore funds or securitization vehicles will want turn-key FATCA/FDAP reporting and withholding services and want to be protected in case of process or other material errors, while other will want to outsource only the withholding duties and will undertake the account identification, diligence and on-going reporting and verification themselves (or visa versa) with varying degrees of contractual protection agreed upon by the parties.

Menu of FATCA/FDAP services by vendors. Presumably, vendors providing these services will establish price points for a menu of services, which may mitigate the FATCA/FDAP exposure depend-ing on among other factors how well the existing

U.S. information reporting platforms function and upon how much resource the firm has allocated to FATCA/FDAP implementation and the development of robust FATCA/FDAP processes, which will need to be coordinated with the Chapter 3 (Code Sec. 1441) and the QI withholding and reporting regime. Some firms may be want to go further to reduce their aggre-gate global FATCA/FDAP risk by obtaining “FATCA/FDAP insurance,” if insurers decide that the various FATCA/FDAP risks for certain products or platforms is a line of business they want to get into once the IRS provides guidance on how FATCA/FDAP is to be implemented.

Certification of FATCA/FDAP compliance for certain products by financial sponsors. In addition, some firms may elect to certify some of their finan-cial products, investment vehicles or platforms with FATCA/FDAP exposure to investors and the market place that the FATCA/FDAP risks have been ring fenced by outsourcing the reporting and withhold-ing responsibilities, contractual indemnities, FATCA/FDAP insurance, or a combination thereof in hopes of gaining some competitive advantage over other similar products marketed by other financial spon-sors. However, this “good housekeeping seal” may be costly to obtain and may give investors and other intermediaries’ additional rights to litigate in the event the IRS finds that the foreign financial institution is not FATCA/FDAP–compliant unless the disclosures in the prospectus or offering documents are drafted very carefully. (See “Investor Disclosure for FATCA”).

For firms with FATCA/FDAP withholding, report-ing or other responsibilities, it can be expected that it will be expensive for a third-party insurer to underwrite the legal and reputational risks (includ-ing the impact on its goodwill and other business platforms) for FATCA/FDAP withholding taxes (es-pecially since the 30-percent FATCA withholding tax is geared in part to withholdable payments from the gross proceeds from the sale of U.S. stock or se-curities), which may be triggered in many cases by process and reporting errors for the U.S. accounts that are not remediated to the satisfaction of the Treasury. Once the legislation becomes effective in 2013, these FATCA risks will likely have to be borne by the firms that are the withholding agents making withholdable or pass-through payments to foreign financial institutions or non–financial foreign entities, or the FFIs or NFFEs themselves that are responsible for the reporting, diligence and verification of the U.S. accounts.


September 2010

Common Types of Withholdable PaymentsThe IRS has identified the following items as examples of FDAP income that may be treated as “withholdable payments” for purposes of new Chapter 4: compen-sation for services; dividends; interest; original issue discount; REMIC excess inclusion income; pensions and annuities; real property income, such as rents, other than gains from the sale of real property; royal-ties; scholarships and fellowship grants; other grants; prizes and awards; sales commissions paid or credited monthly; commissions paid for a single transaction; distributable net income of an estate or trust that is FDAP income and that must be distributed currently or has been paid or credited during the tax year, to a nonresident alien beneficiary; distributions from a partnership that is FDAP income or such an amount that although not actually distributed is includible in the gross income of a foreign partner; taxes, mortgage interest or insurance premiums paid to or for the account of a nonresident alien landlord by a tenant under the terms of a lease; prizes awarded to nonresi-dent alien artists for pictures exhibited in the United States; and purses paid to nonresident alien boxers for prize fights in the U.S. prizes awarded to nonresident alien professional golfers in golfing tournaments in the United States.17In addition, REIT distributions to foreign financial institutions or non–financial foreign entities giving rise to ordinary dividends, capital gains or return of basis and income received under life insurance or annuity contracts issued by a U.S. life insurance company or a foreign branch of a U.S. life insurance company18 may be considered withhold-able payments when the IRS provides guidance.

Since an individual is not included in the definition of foreign financial institution or non–financial foreign entity, the above payments, which are paid directly to an individual and not to his or her foreign entity, will not be treated as withholdable payments for purposes of new Chapter 4, but may continue to be subject to U.S. withholding tax under Chapter 3.19

Exclusions. While not currently excludable from the term “withholdable payment,” the following income was not generally subject to tax withholding under the U.S. tax law prior to the HIRE Act and may be excluded as withholdable payments as the Treasury provides guidance in the near future: portfolio interest on bearer obligations or foreign-targeted registered obligations if those obligations meet certain require-ments (see “Repeal of certain foreign exceptions to

registered bond requirements”); interest on deposits (bank deposit interest that is not effectively connected with the conduct of a U.S. trade or business); original issue discount on obligations payable 183 days or less from the date of original issue; original issue discount paid on the sale of an obligation other than a redemp-tion; amounts paid as part of the purchase price of an obligation sold between interest payment dates; nonbusiness gambling income of a nonresident alien playing blackjack, baccarat, craps, roulette or big-6 wheel in the United States; and insurance premiums paid on a contract issued by a foreign insurer. 20

Presumably, the fact that the FDAP income has not actually been currently paid to the payee will not mat-ter for purposes of new Chapter 4. Thus, a dividend which is declared but unpaid will likely be includable in the term “withholdable payment.” Because new Code Sec. 1473(1) includes in the term “withhold-able payment” “any gross proceeds from the sale or other disposition of any property of a type which can produce interest or dividends from sources within the United States,” it is unclear whether a corporation making a distribution with respect to its stock or any transfer agent or other intermediary making a pay-ment of such a distribution is required to withhold on the distribution to a noncompliant foreign financial institution or noncompliant non–financial foreign entity for the following distributions: a nontaxable distribution payable in stock rights; a distribution in part or full payment in exchange for stock; a disposi-tion of Code Sec. 306 stock,21 a distribution that is not paid out of current or accumulated earnings and profits; and a distribution that represents a capital gain distribution or an exempt interest dividend by a regulated investment company or is already subject to withholding under Code Sec. 1445 (withholding on the disposition of U.S. real property interests and the distribution corporation is a U.S. real property holding corporation) or qualified investment entity.

Financial products. It is quite likely that the Treasury will also include in the concept of “withholdable payments” payments from various financial products that may generate U.S. source income. One approach may be for the Treasury to use the same definition (as expanded by regulatory guidance in the near future) that they decide to use for new Code Sec. 6038D for purposes of individual reporting of “specified for-eign financial assets,” or “SFFAs,” on an individual’s income tax return if the aggregate value of all such assets exceeds $50,000 beginning for tax years in 2011. New Code Sec. 6038D(b)(2)(A) includes “any

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financial instrument or contract held for investment that has an issuer or counterparty which is other than a United States person.”

Presumably, forward contracts, repurchase agreements or repos, sweep accounts, securities lending—substitute dividends and interest, certain options, various types of derivatives such as caps, collars and floors, commodity based derivatives and certain contracts, annuities and many other structured financial products that may be packaged as invest-ment units or wrappers may be swept in under this definition. In addition, it can be expected that with-holdable payments under new Code Sec.1471 will include certain payments arising in connection with securities lending and notional principal contracts including (i) rebate fees (interest paid by U.S. lenders), (ii) U.S. source borrow fees paid by U.S. borrowers, (iii) substitute U.S. interest/dividend payments, and (iv) outbound repo spreads (interest).22

Withholding on gross proceeds. The new law also includes within the term “withholdable pay-ments” “any gross proceeds from the sale or other disposition of any property of a type which can produce interest or dividends from sources within the United States.”23

In general, Code Sec. 6045 requires the reporting by a broker (i.e., the person that effectuates sales for another person)24 of the gross proceeds from the sale of certain securities. Reg. §1.6045-1(a)(9)de-fines a “sale” to mean “any disposition of securities, commodities, regulated futures contracts or forward contracts for cash, and includes indebtedness, and entering into short sales … .” (Emphasis added.) The instructions to Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, indicate a broker must file a Form 1099-B for each person for whom the broker has sold (including short sales) stocks, bonds, commodities, regulated futures contracts, foreign currency contracts (pursuant to a forward contract or regulated futures contract), forward contracts, debt instruments, etc., for cash, who received cash, stock, or other property from a corporation that the broker knows or has reason to know has undergone a reportable change in control or substantial change in capital structure, or who exchanged property or services through a barter exchange.

One commentator has suggested that the phrase “or other disposition” in the final version of the law “actually goes far beyond [Code Sec.] 6045 requirements for withholding domestically on gross proceeds.”25

Investor Disclosure for FATCA

The new law is effective for payments made after December 31, 2012.26 However, the new law has a grandfather rule that does not require any amount to be withheld from any payment under any obligation outstanding on the date that is 2 years after the date of enactment (e.g., March 18, 2012) or from the gross proceeds from the disposition of such obligation.27 If a new or existing offshore securitization, mutual or investment fund with U.S. accounts or other offshore vehicle with substantial U.S. owners seeks to raise capital by going to the debt or equity markets (as-suming the Treasury takes a broad view of the term “obligation”—see “Effective Date and Grandfather Treatment for Outstanding Obligations”), it may be prudent to include appropriate FATCA disclosure, which at a minimum discusses the requirements for a foreign financial institution or non–financial foreign entity under new Code Sec. 1471(b) or 1472(b), if any exemptions apply and importantly the conse-quences for failure to be FATCA compliant after the effective date. Presumably, grandfathered offerings, which by their terms offer investors the possibility of reinvestment after March 18, 2012, may need this disclosure now.

Treasury Guidance on Customer Accounts and Best Practices for Customer Accounts

The IRS is planning to issue guidance this summer on FATCA and it looks like the initial guidance will address customer identification issues. This may be favorable news because it may reflect that the Treasury is taking a practical view and permitting a reasonable approach to address the identification of a huge number of accounts, most of which will not be U.S. accounts at all.

According to Steven Musher, Associate Chief Coun-sel at a recent Federal Bar Association conference, the IRS is planning to include as many issues as it can in the first wave of guidance on FATCA and suggested that it is seriously being considered to have different levels of obligations for existing versus new accounts and that the government would be taking a process oriented approach—that is, focusing on compliance processes hopefully from a macro perspective.

Rather than reinventing the wheel, it is hopeful the Treasury will accept existing AML and KYC


September 2010

rules with some necessary tweaks for FATCA (e.g., the Treasury may need to require follow-up rules on certain documentation issues when AML/KYC procedures allow reliance on work done in other countries, especially those which are not U.S. treaty partners with robust information sharing clause. We are hopeful the Treasury will allow foreign financial institutions to take reasonable steps to modify its ac-count opening procedures to gather information that reasonably would identify U.S. tax residents, such as place of birth, citizenship, home address, TINs and country of residence.28

This information can be cross-checked against any AML and KYC information that might also be collected during the account opening process (e.g., passports, driver licenses, identity cards, etc.). It may be a good idea to adopt non–U.S.-centric require-ments for foreign financial institutions so that they can begin to collect information and coding their systems with information that ultimately may be required by the tax authorities of other jurisdictions.

Legacy Accounts and SystemsIt is likely procedures to verify legacy accounts will have to be provided by the Treasury and provide phased-in effective dates with a longer time horizon then the current 2013 effective date for the balance of the FATCA provisions.

In the case of investments in U.S. securities foreign financial institutions typically can collect either a U.S. tax document (e.g., W-8, W-8BEN or W-9) or an appropriate KYC-type document to establish status for Chapter 3 purposes, and presumably could do the same for Chapter 4 or FATCA purposes. If the information collected conclusively established U.S. tax status (e.g., a U.S. passport was provided), then the foreign financial institution can solicit the U.S. person’s TIN and code its system accordingly. If the information only gave rise to a reasonable believe of U.S. tax status (e.g., a U.S. tax address), then the foreign financial institution can gather additional information and/or documentation to conclusively establish U.S. or non-U.S. status.29

The regulations should be flexible enough to provide for the use of different AML and KYC pro-cedures and other cross-checks to identify the status of customer accounts that in many cases will be in different countries and that may have different AML and KYC standards, as well as consider the fact that many systems and processes will now be manual

processes or excel spreadsheets in some cases, or will be coded in different programming languages or have a limited number of fields and may now provide information for regulatory and other purposes which is not relevant to the information FATCA requires about the accounts.

Put simply, the IRS when drafting these regulations must consider the fact that automated (and manual) processes and systems of many foreign financial institutions with global footprints are not integrated systems with state of the art technology platforms, but represent separate systems set up along business lines and/or country-specific requirements and have been cobbled together over time as a result of acquisitive or merger activity.

Use of statistical sampling techniques to determine U.S. accounts and other verification processes. Will the IRS permit a foreign financial institution to use ac-ceptable statistical sampling techniques as a method to either determine or validate its U.S. accounts? In the past in other areas the IRS has permitted the use of probability samples and has issued at least two Field Directives30 on the use of such samples, one of which was issued as recently as November, 2009. This Direc-tive was not aimed at any particular credit, deduction or tax issue but instead provided general guidance as to when a sample may be appropriate for a taxpayer. Under this Directive probability samples are con-sidered appropriate whenever there is a compelling reason to use them and more accurate information does not exist. For this purpose, appropriateness to use includes the time and cost required to analyze large volumes of data requiring facts and circumstances determinations.31Presumably, the IRS will provide guidance which will establish guidelines to use statis-tical sampling techniques to determine U.S. accounts including the amount of precision required (e.g., the accuracy of the sample estimate) or confidence inter-val, the acceptable margin of error or sampling error, the relative precision (e.g., the margin of error divided by the estimate) and any exemptions or exclusions from having to sample entire account populations and permit the use of smaller samples where appropriate because of the low risk of tax evasion.

Waivers for U.S. Accounts and Problems Closing AccountsIn recent comments32 to the Treasury, the RBC Fi-nancial Group raised a number of issues relating to obtaining waivers of privacy laws for U.S. accounts

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and problems which may arise with closing the ac-counts if a waiver cannot be obtained:

Under the terms of an FFI Agreement, if there is any foreign law that would prevent the reporting of information with respect to any United States account, the financial institution is required to attempt to obtain a valid and effective waiver of such law from each holder of such account, and if such a waiver is not obtained within a reason-able period of time, to close the account.

As these provisions only apply to United States accounts, in the case of an account that is recalci-trant as a result of the FFI not being able to obtain sufficient information in order to determine whether or not the account is a United States account, the account should not be treated as a United States account, particularly where there are no U.S. indicia. The implications of these requirements are complex and require further research into the relevant laws of several juris-dictions. We understand that various comments have already been submitted to Treasury and the IRS on this subject, including the fact that FFIs are entering into FFI agreements voluntarily and therefore may not be able to rely on provisions in the legislation of some jurisdictions which would otherwise permit the disclosure of information without consent if the such disclosure is for the purposes of complying with foreign laws.

Some of the other issues that we are still reviewing include the following: obtaining waivers in the case of a United States owned foreign entity to permit the disclosure of information related to the entity; obtaining waivers in the case of joint accounts where the account is set up in the name of all par-ties to the account, some of whom may not be U.S. persons; the inability to “close the account” in the case of an annuity contract, life insurance policy or a trust (where the FFI is also trustee).

Clarify Scope of the Term “Financial Account”: U.S. Brokers, Swap Dealers or Nominees and DAP PaymentsU.S. brokers, swap dealers or nominees. The term “U.S. account” means any financial account that

is held by one or more “specified United States persons” or U.S-owned foreign entities.33 One commentator a the recent KPMG webcast34 sug-gested that while the new law provides for certain exclusions from the definition of specified U.S. person,35 it does not explicitly exclude U.S. brokers, swap dealers or nominees so that the reporting requirements now apply to accounts held by these individuals [and presumably other U.S. persons unless excluded by the statute or by the Treasury] in these categories as well.

DAP payments. In recent comments36 to the Trea-sury, the RBC Financial Group raised the issue that delivery against payment or “DAP” accounts with broker dealers be excluded from the definition of financial accounts because these accounts present a low risk of tax evasion with the following analysis:

We also recommend that delivery against pay-ment (“DAP”) accounts with broker dealers(also known by such other names as “cash on de-livery”, “delivery versus payment”, etc.) be excluded on the basis that the broker dealer is simply the intermediary that is executing trades on behalf of the beneficial owner, and such transactions are also reported by a financial in-stitution (“FI”) that maintains a custodial account for the beneficial owner. As all transactions pro-cessed by the executing broker are also reported by the FFI that maintains the custodial account, we suggest that the reporting by the executing broker would be duplicative. In addition, if an FFI that maintains the custodial account is not a participating FFI, all withholdable payments made to the non-participating FFI for the benefit of the account holder would be subjected to 30% withholding. Therefore, we propose that DAP accounts be excluded on the basis that re-porting would be duplicative and that the other reporting with respect to these types of accounts ensure that they present a low risk of being used by U.S. persons for tax evasion.

Investment Fund—FATCA IssuesSeveral investment fund FATCA issues have re-cently surfaced which may be worthwhile briefly discussing. One commentator37 has focused on the Code Sec. 1471(b) compliance requirements by focusing on interests sold through distributors/intermediaries which are foreign financial institu-


September 2010

tions and investments made by foreign financial institutions and in the context of fund of funds (FOFs) by providing:

In the case of a collective investment fund (whether widely-held or otherwise) which sells its interest via a distributor or intermediary, there may be valid commercial reasons which preclude the distributor/intermediary from disclosing the identities of the underlying investors in the fund. To illustrate this point, we wish to highlight a scenario which is common in practice.

A Luxembourg issuer distributes paper with UCITs brand name through DL bank. 38 DL Bank is solely a distributor/paying agent and it places the Luxembourg issuer’s paper with its own pri-vate wealth clients. DL Bank acts as agent with respect to payments, although it does not tell the Luxembourg issuer the identity of the owners of the paper. The reason for this is that DL Bank does not want to disclose its own private wealth clients because the Luxembourg issuer is connected to a rival bank that will try to poach those clients.

The paper is either debt or equity interest in the Luxembourg issuer and therefore an ac-count. Assuming DL Bank is an FFI, it will have entered into an FFI agreement and reported the holders of the paper as custodial account. Where the Luxembourg issuer is also an FFI, it will need to obtain information as to the U.S. and foreign accounts and report to the IRS. The Luxembourg issuer would need to now who owns its paper in order to comply with an FFI agreement with the IRS. However, because DL Bank will not disclose who is holding the paper, the Luxembourg issuer cannot comply with the FFI agreement. Thus, absent an exemption, the Luxembourg issuer will suffer U.S. withholding tax on U.S. source dividend or interest income that is linked to the paper which is distributed by DL Bank.

The same issue is likely to arise in the context of a fund of funds (FOF), i.e., a fund which invests in other underlying funds. A FOF will generally resist disclosing its investors to an underlying fund to prevent them competing for the FOF’s clients. Provided the FOF has en-tered into an FFI agreement and disclosed the

relevant information to the IRS, we believe that the underlying fund should be deemed to meet the reporting requirements of [Code Sec.1471 if it obtains a statement from the FOF which certifies that the FOF has entered into an FFI agreement with the IRS and has complied with its reporting obligations in relation to any U.S. accounts. Similarly, in the first scenario above, it should be sufficient that the Luxembourg is-suer obtains a statement from DL Bank that the distributor has entered into an FFI agreement and provided all relevant information to the IRS. This solution would, in our view, be con-sistent with the objectives of FATCA whilst at the same time preventing duplicative reporting and/or unnecessary withholding. As to a related point, the regulations should provide guidance on whether an administrator of an FFI can rely on certification provided by a third party. For example, in the FOF example above, it would be more practical if the underlying fund’s ad-ministrator could rely on a statement provided by the FOF’s administrator rather than having to obtain certification from the FOF directly.

RBC Comments on investment funds. The RBC Comments39 provided the following discussion pertaining to investment funds and in particular addressed the implementation of pass-through payments to offshore investment fund recalcitrant account holders by providing:

RBC will be impacted from a number of perspec-tives by the requirements contained in the final FATCA regulations and guidance as they may apply to funds (and other collective investment vehicles (“CIVs”) and their investors. In addition to offering a wide-range of RBC-managed mutual and pooled funds in Canada, Jersey, Guernsey and Switzerland, RBC offers a variety of services to funds and their investors. For example, RBC and third party Canadian retail funds can be purchased, sold and held by clients through accounts opened and maintained with RBC’s Canadian bank branches. RBC and third party funds can also be purchased, sold and held by clients through accounts opened and maintained with RBC’s broker/dealers and several RBC enti-ties that offer custodial services. RBC provides a variety of services to the funds themselves, including investment management, trusteeship,

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custody, fund accounting, net asset valuation, and unit holder recordkeeping. It is important to note that it is not unusual for RBC to provide only some of these services to a fund. A fund may engage separate service providers for different fund-related activities.

The manner in which the units of many funds are distributed, registered and held creates sig-nificant practical operational challenges that would make it very difficult (if not impossible) for most funds to comply with the requirements of an FFI Agreement as an FFI. The funds them-selves may have very little information about the unit holders of the funds if units of the funds are distributed through other intermediaries or even a chain of intermediaries. This makes it opera-tionally difficult for the fund to be responsible for the identification and reporting of any United States accounts.

Another aspect of FATCA (as it might apply to funds) that concerns RBC relates to any potential requirement to withhold on pass-through pay-ments made to recalcitrant account holders. It is difficult to see how this could practically be implemented in the case of funds (or other CIVs). Some of the challenges include the following:

Determining at what point withholding should be applied (e.g., when a withholdable pay-ment is made to the fund, when a distribution is made from the fund to an investor, etc.).Identifying recalcitrant accountholders subject to withholding on any pass-through payment where the entity that is identified as respon-sible for withholding is not the entity that identifies recalcitrant accountholders. This requires that information be communicated between intermediaries, or potentially through a chain of intermediaries. This would be an extremely burdensome process which would likely need to be performed manually.Measuring the portion of a payment made to a recalcitrant account holder that would be considered to be a pass-through payment subject to withholding and applying the tax. Given that a unit holder of a fund does not generally have a dividend interest in any of the assets of the fund and, in many funds, investors change on a frequent basis, it is

unclear how this amount would be calcu-lated. This would seem to be particularly true in the case of proceeds, given that funds generally only allocate net capital gains to unit holders. Any effort to allocate proceeds would be a potentially greater challenge. In Canada, most funds only make capital gains distributions to investors holding units at the end of the taxation year. Given that the vast majority of fund units are held in accounts with other FFIs that may be participating FFIs which would be taking steps to identify United States accounts and to report such accounts to the IRS, we submit the following for consideration:Exclude funds from the definition of “financial institution,” in which case the FATCA provi-sions applicable to NFFEs would apply. Funds or groups of funds that have the ability to com-ply with the terms of an FFI agreement could be given the option to elect FFI treatment.Provide an exclusion from the definition of ”United States account” for funds that are widely-held. (We understand that sev-eral interested parties have suggested that “widely-held” should be defined to include funds with more than 100 investors, and we support this recommendation.) Given that most funds will likely be held in accounts with participating FFIs, it is likely that in-vestors in such funds will be identified and reported by such FFIs. To also impose report-ing requirements on the fund would result in duplicative reporting.As a general rule, exempt any portion of a U.S. source payment made to a fund with recalcitrant account holders, as well as any payment made to a recalcitrant account holder receiving a distribution from a fund that receives U.S. source income and pro-ceeds, from Chapter 4 withholding. As a minimum, we suggest that any such with-holding requirements be suspended during an appropriate transition period in order to allow time to address any recalcitrant ac-count holder situations. We anticipate that most participating FFIs will have very few recalcitrant accounts among new accounts opened on or after the effective date for the new requirements. If it is felt that there are situations where there is the potential


September 2010

of abuse, the more immediate application of the withholding requirements should be directed to those situations (e.g., funds that have a significant percentage of units held by recalcitrant accounts holders).”

Trusts—FATCA IssuesThe RBC Comments40 provided an extensive dis-cussion of FATCA issues relating to trusts and trust companies with the following excellent analysis:

The application of FATCA to trust companies and personal trusts (i.e., trusts settle by and for the benefit of private individuals as opposed to commercial trusts or collective investment ve-hicles, an interest in which is typically defined by reference to units, which a beneficiary (or investor) acquires for consideration) is an area of concern to RBC. A number of RBC entities in several jurisdictions act in a fiduciary capacity as trustee of such personal trusts. In addition, the majority of RBC FFIs have accounts for entities that are trusts. These trusts may have corporate or personal trustees. In that con-nection, we submit that the regulations and guidance should clearly define the application of the FATCA rules to various types of trusts and trust arrangements.

1. Trust Companies as FFIs versus Trusts as NFFEs. FATCA defines a “financial institution” to include any entity that, “as a substantial por-tion of its business, holds financial assets for the account of others”. While it could be argued that a corporate trustee holds financial assets for the benefit of beneficiaries of a trust, we recom-mend that a distinction be made between trust companies that retain custody of trust assets (i.e., effectively providing both trustee and custodial services) and trust companies that open financial accounts with other FFIs which hold custody of trust assets (i.e., providing trustee, but not custody services).

In the first situation, the trust company will have robust custodial recordkeeping and reporting systems, and generally have the capabilities to make the changes necessary to comply with the terms of an FFI Agreement. In the second situ-ation, the trust company may not have robust

electronic recordkeeping systems, especially with respect to the recording and reporting of transactional data, as they have not had the need for such systems in order to fulfill their fiduciary responsibilities. Instead, they may rely on the recordkeeping and reporting services provided by the financial institutions where they maintain financial accounts.

In the case of a trust company that opens fi-nancial accounts for trusts with other FIs (i.e. “holding FIs”), we propose that the final regula-tions and guidance provide flexibility to allow the trust company to have the holding FI treat the account as an account for the trust company as an FF1, or to treat the account as an account for an NFFE (i.e., the trust). In the first situation, the trust company will be responsible for the identification and reporting of any trusts that are United States owned foreign entities. In the second situation, the trust company will either provide the holding FI with a certification that the trust does not have any substantial United States owners, or will provide the name, ad-dress and TIN of each substantial United States owner of the trust.

2. Identification of “substantial United States owners” of a Trust. In the case of trusts that are not collective investment vehicles, FATCA generally defines a “substantial United States owner” to be any specified United States person: treated as an owner of any portion of the trust under the U.S. grantor trust rules, and to the extent provided by the Secretary in regulations or other guidance, who holds, directly or indirectly, more than 10 percent of the beneficial interests in the trust.

Unless the regulations and guidance provide greater clarity regarding the identification of substantial United States owners of a trust, we an-ticipate that making this determination will create significant on-going problems, including client frustration and dissatisfaction, administrative costs related to the additional time that will be spent on such accounts, and frequent uncertainty as to whether the rules have been applied cor-rectly. Given that the majority of these accounts are unlikely to be United States accounts, it is our view that the burden on the FFI will significantly outweigh any benefit derived by the IRS.

40


In that connection, we are familiar with the difficulties that can arise as a result of to ap-plying complex U.S. tax rules to non-U.S. entities in an effort to determine the type of documentation that is required under QI Agree-ments. Given that the number of accounts that will likely be affected by FATCA is far greater than the relatively small number that currently operate under QI Agreements, it is our sincere hope that such uncertainty can be addressed for participating FFls under the proposed FATCA regime. In that connection, it should also be noted that these difficulties will likely be even more pronounced for the non-corporate trustees of trusts for which RBC has financial accounts. Many of these trusts are small and have non-professional trustees.

We submit that non-U.S. trustees should not be expected to engage U.S. tax advisors to advice on the application of these complex U.S. defini-tions to their trusts. Similarly, the employees of FFls should not be expected to assist clients in the interpretation of the U.S. trust provisions.

Issues of particular concern include the following:

Identification of an owner under the complex grantor trust rules. We are concerned that the far-reaching definition could result in a non-U.S. inter-vivos trust inadvertently having a U.S. owner as a result in a change of residence of a contributor or beneficiary of the trust.Identification of persons with a beneficial in-terest in a non-grantor trust. We propose that such persons be limited to those beneficiaries having a current vested entitlement to revenue and/or capital from the trust.Measurement of a person’s beneficial inter-est in a non-grantor trust. Although this may be simpler to measure in the case of a non-discretionary trust, there is still uncertainty as to how to measure against the 10% threshold when some beneficiaries’ entitlements may be limited to a fixed share of only the revenue or only the capital of the trust. In the case of a discretionary trust, the basis for measurement is even less clear. Given that a discretionary beneficiary has no actual entitlement until the trustee takes the necessary steps to exercise its discretion in favour of the beneficiary, it could

be argued that in the case of a discretionary trust, no beneficiary has a beneficial interest in excess of 10%.

Similar issues would exist under U.S. tax rules that require a U.S. person to report certain in-terests in passive foreign investment companies (“PFICs”). We understand that there is little or no guidance regarding the attribution of stock ownership in a PFIC to a beneficiary of a fully discretionary trust. We also understand that the IRS considered this in a private letter ruling, in which it suggested that patterns of distributions and mortality tables based on the age of each beneficiary could be analyzed to determine the actuarial interest of a beneficiary.

Equally, in the case of trusts where the distribution of capital is contingent on a future event (such as the death of the revenue beneficiary), the indi-viduals entitled to the capital, and their respective share, cannot be determined definitively until that future vent occurs. We suggest that it would be very difficult for non-U.S. trustees to correctly interpret, analyze and apply these rules.

3. Privacy and Other Regulatory Concerns. In the case of a trust (or other NFFE) that is determined to be a United States owned foreign entity, it is not only the information relating to the United States substantial owner that is being reported to the IRS, but also the information relating to the entity itself. We have not yet had an opportunity to consider the more complex issues that may arise in this situation as a function of the varied and robust privacy and confidentiality laws which govern our operations.

4. Requirement to Close a United States Ac-count. Under the terms of the FFI Agreement, a participating FFI may be required to close a United States account that does not provide a waiver of a foreign law that would otherwise prevent the reporting of required information related to the account to the IRS. Although it may be possible for an FFI that has a United States account for a trust to close the financial account, it seems less likely that a participating FFI that is trustee can simply “close” or ‘terminate” the trust. Being a fiduciary relationship (as opposed to a contractual account), the FFI trustee faced


September 2010

with this position might have two options: (i) retire as trustee in favour of another trustee that is likely to be faced with the same issue and there-fore may be difficult to find; or (ii) appoint the assets to a beneficiary, thereby terminating the trust. Any such fiduciary decisions not taken in the best interests of the beneficiary could leave the trustee exposed to a breach of trust claim. This issue is being considered further.

5. Inter Vivos Trusts versus Testamentary Trusts and Estates. Given our understanding of the policy rea-sons behind the FATCA legislation, we propose that consideration be given to limiting the application of FATCA to inter vivos trusts (i.e, trusts created during the lifetime of the settlor), and exempting estates and testamentary trusts (i.e., trusts arising under the will of an individual following their death). In our Canadian trust business, where RBC acts as corporate executor and trustee, the majority of the accounts are estates or testamentary trusts. Canadian anti-money laundering legislation and regulation also reflects the policy difference between inter vivos and testamentary trusteeships and has tailored the collection of information and reporting requirements accordingly. We propose that estates and testamentary trusts be excluded on the basis of presenting a low risk of being used by U.S. persons for tax evasion.”

FATCA Reporting Responsibilities—Gross Receipts and Withdrawals

RBC Comments on FATCA reporting. The RBC Com-ments41 discussed numerous FATCA reporting issues which the Treasury may want to address with the following analysis:

We are concerned that the reporting of financial information, particularly gross receipt and gross payments/withdrawals from an account may prove to be of limited value to the IRS and would at best only identify potential U.S. persons for further review. The information would not neces-sarily be indicative of amounts to be reported on a U.S. tax return.

Given that reporting of information based on transactional data is generally more complicated

and costly from a systems perspective than report-ing static data such as name, address and TIN, and account balance/value which is captured at a particular point in time, we recommend that the reporting of gross receipts and gross withdrawals/payments not be required as part of the annual filing, and that Treasury instead exercise its au-thority under the terms of the FFI Agreement to request the FFI to provide additional information with respect to any United States account.

We also suggest the benefit of reporting account balance/value be reconsidered to ensure that IRS will in fact be able to make effective use of the information to warrant the cost to FFIs of provid-ing such information.

If Treasury and the IRS do conclude that the reporting of any financial information is neces-sary, we suggest a deferral of the effective date of such reporting be provided to reduce the strain that implementing the FATCA provision will place upon the

Information Technology resources of FFIs. We also suggest the following with respect to reporting -

The default reporting period should be the calendar year.The filing deadline should be no sooner than June 30th following the year-end.There should be no requirement to send cop-ies of the information reported to the IRS to the account holder or substantial United States owner, although most FFIs would likely advise such persons that information regarding their account will be reported to the IRS.If FFIs are required to report account value/ balance:The amount should be reported as at close of business on December 31.The FFI should be permitted to report in the base currency of the account.The method for determining account value should be based on existing procedures and practices. For example, if there are holdings in an account that an FFI does not currently value because of the difficulty of obtaining a current value, there should be no requirement to obtain a value for purposes of reporting under the FFI agreement.

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There may be other amounts and adjustments being posted to accounts that do not represent receipts or withdrawals/payments. For many FFIs, it may be difficult and costly to segregate such amounts from actual receipts; withdraw-als and payments. Given the values will be of limited use in any case, we recommend that FFIs be permitted to simply report total debits and total credits to an account.Many FFIs that offer a variety of products will have accounts on a number of different systems. FFIs should be permitted to submit the required reporting information separately for each system. Similarly, if members of the same expanded affiliated group are covered under a single FFI agreement, each member should be permitted to submit their report-ing separately. We submit that there should be no requirement for an FFI to aggregate their annual reporting to the IRS. Such a requirement would place an unnecessary financial and administrative burden upon FFIs, particularly in situations where filing is done electronically.

One commentator42 also raised several relevant issues relating to the FATCA reporting requirements by providing:

[The] forthcoming Treasury regulations under FATCA should clarify four main issues for tax-payers regarding the scope and scale of the reporting requirements. They must: (i) clearly define what is to be reported and provide ex-amples (including those applicable to reporting by foreign investment funds) (ii) clarify whether the IRS requires a complete transcript of ac-count movements, or information about certain transactions only (iii) clarify that the investment activity of an FFI – for example, an investment fund –itself does not need to be reported, but only U.S. account holders’ subscriptions and redemptions and (iv) address how foreign enti-ties whose values are denominated in foreign currencies should be reported.

FATCA also requires reporting of the account balance or value, as well as the gross receipts and withdrawals of all Reportable Accounts. In lieu of reporting account values, receipts and withdrawals, an FFI may elect and report under

[Code] Sec. 6041, 6042, 6045, and 6049 as if it were a U.S. person. The reporting guidelines should clarify that neither a complete record of account movements nor a description of a fund’s investment activities is required. A clause specifically excluding such information from the requirements should be added.

FATCA also requires reporting of each Report-able Account’s account number, but private investment funds generally do not have account numbers. Therefore, this requirement should be deleted or perhaps replaced with the date on which the account was created. For account balance or value, a figure such as year-end net asset value would be most appropriate and useful reporting requirement for most hedge funds, as hedge funds generally do not calculate net asset value on a daily basis.”

Financial Accounts. Guidance is required which clarifies and limits the definition of a “financial account”—as defined in [Code] Sec. 1471(d)(2)—in connection with certain financing and hedging transactions. Certain investment products—such as total return swaps and other derivatives –provide exposure to a fund’s per-formance, but should be expressly excluded from ‘financial account’ classification, given that a fund does not have access to the party to the derivative and the party has not ultimately invested in the fund. The Secretary should also make clear whether short-term obligations or short-term deposits that pose a low risk of U.S. tax evasion (e.g., those with a term of no more than one year) will be treated as “financial ac-counts” under FATCA.

The Regulations should also establish whether, for purposes of Section 1471, “regularly traded on an established securities market”—given the cross border context—will retain the same meaning used in [Code] Sec. 897, 1445, and 6039C: Treasury Regulation Section 1.897-1-(m)—Established securities market. For purposes of [Code] Sec. 897, 1445, 6039C, the term ‘es-tablished securities market” means: (i) A national securities exchange which is registered under section 6 of the Securities Exchange Act of 1934 (15 U.S.C. 78f) (ii) a foreign national securities exchange which is officially recognized, sanc-


September 2010

tioned, or supervised by governmental authority, and (iii) any over-the-counter market. An over-the-counter market is any market reflected by the existence of an interdealer quotation system. An interdealer quotation system is any system of general circulation to brokers and dealers which regularly disseminates quotations of stocks and securities by identified brokers or dealers, other than by quotation sheets which are prepared and distributed by a broker or dealer in the regular course of business and which contain only quo-tations of such broker or dealer.

Regulations should address over-the-counter markets specifically. FATCA provisions as en-acted will also require further clarity in debt and distress market contexts. The Regulations should clarify what debt interests are considered “financial accounts” and address situations that include (i) private placements debt where third party invests are unknown to the fund, and re-purchase agreements, total return swaps, and other leverage undertaken with dealers who themselves may be U.S. persons or FFIs where such arrangements do not pose a significant risk of tax evasionDeep-in-the-money options, non-debt open transactions—for example, pre-paid forward contracts and credit default swaps will also require consideration in published guidance if FFIs are to understand how to ap-ply FATCA.

Consolidated or Separate FFI AgreementsIt is presently unclear whether the Treasury will per-mit the Code Sec. 1471(b) agreement to be entered into on a consolidated basis for the foreign financial institution and its global businesses or whether separate FFI agreements may be entered into. If a global business has multiple foreign financial institu-tions and the IRS permits consolidated or separate filing, the business may want to consider whether principles under Reg. §1.1502-6 may be followed—that is, will all members of the expanded affiliated group who have entered into a consolidated FFI agreement be jointly and severally liable for the FATCA requirements of each member of the group? Will the same FATCA exposure be present for the expanded affiliated group even if the FFIs each have a separate FFI agreement?

In addition, if a company purchases another foreign financial institution that was a party to a con-solidated FFI agreement, will the acquiring company be responsible not only for the FATCA liabilities of the acquired foreign financial institution’s, but also the FATCA liabilities of the other foreign financial institutions that were a party to the consolidated FFI agreement, absent contractual indemnities to protect itself?

Distinguishing Between Foreign Financial Institutions and Non–Financial Foreign Entities

There will undoubtedly be pressure to distinguish be-tween foreign financial institutions and non–financial foreign entities. As a preliminary matter, for purposes of analysis and in order to make sure as many carve-outs from FATCA are identified as possible, it may be a good idea to bucket the foreign entities into various categories, such as (i) foreign financial institutions (ii) excluded foreign financial institutions (from FFI status) (iii) non–financial foreign entities (including possible FFI “lite” entities) (iv) excluded NFFEs (e.g., nonfinancial publicly traded corporations) (v) foreign financial institutions and non–financial foreign enti-ties excluded from Chapter 4 completely, and (vi) entities excluded from Chapter 4 by statute (e.g., an international organizations). After the IRS provides guidance, these categories may be reduced to three buckets each with separate rules (or lack thereof) (i) foreign financial institutions (ii) non–financial foreign entities (including FFI lite entities), and (iii) FATCA-exempt entities.

Why Is It Important to Distinguish Between FFIs and NFFEs? Increased Reporting Requirements and Zero Ownership Threshold in Foreign Investment Vehicles (a Wider Net)A foreign financial institution’s reporting require-ments for its U.S. accounts will be considerably more onerous than for a non–financial foreign entity. It will be required to report the name, address, TIN, account number, account balance or value and possibly the

44


gross receipts and gross withdrawals or payments from the account. 43

For this purpose, a U.S. account includes the financial accounts held by specified U.S. persons or United States owned foreign entities.44 The term “U.S. owned foreign entity” means any entity that has one or more substantial U.S. owners45 —a for-eign investment vehicle will be deemed to be U.S. owned foreign entity since zero-percent ownership will trigger the reporting requirement.46 A non–financial foreign entity may also be a U.S.-owned foreign entity if the foreign entity has one or more substantial U.S. owners based on the higher more than 10-percent vote or value test.47

Reporting. A foreign financial institution must re-port the “financial accounts” held by specified U.S. persons regardless of the amount of ownership48 (un-less the aggregate value of the depository accounts held by an individual does not exceed $50,000)49 or U.S. owned foreign entities with substantial U.S. owners (generally more than 10 percent by vote or value,50 unless the entity is a investment vehicle and the ownership threshold goes to zero).51 Financial ac-counts for this purpose include depository accounts, custodial accounts and non–publicly traded debt and equity in such foreign financial institution.52 A non–financial foreign entity must generally report the identity of the specified U.S. persons who own more 10 percent of the entity or certify it has no substantial U.S. owners of the entity.53

Type of information reported. A foreign financial institution must report the name, address, TIN of each specified U.S. person and the name, address and TIN of each more-than-10-percent owner of each U.S. owned foreign entity (or zero percent for investment vehicles), the account number, account balance or value and possibly the gross receipts and gross withdrawals of payments from the account.54 A non–financial foreign entity must report the name, address and TIN of each substan-tial U.S. owner. 55

Alternative to FATCA reporting. A foreign financial institution may make an election under new Code Sec. 1471(c)(2) to elect to be subject to the same reporting as a U.S. financial institution (e.g., 1099 reporting). A non–financial foreign entity does not have a similar alternative to reporting.

Verification and due diligence. A foreign financial institution will be subject to more robust verification and due diligence with the IRS.56 A non–financial foreign entity must either certify that the beneficial

owner does not have any substantial U.S. owners or provide the required information with respect to each substantial U.S. owner.57

Requests for additional information. A foreign financial institution must comply with requests for additional information about the accounts under its Code Sec. 1471(b) agreement with the IRS.58 A non–financial foreign entity has no such requirement.

Obtain valid waiver of privacy laws. A foreign financial institution must attempt to obtain a valid waiver of any foreign privacy laws or close the ac-count within a reasonable time.59 A non–financial foreign entity does not have to obtain a privacy waiver or close the account if it does not obtain the beneficial owner information under new Code Sec. 1472(b), although it may itself be subject to a 30-percent tax on withholdable payments it receives.

Deduct and withhold 30 percent from any pass-through payment. A foreign financial institution must withhold 30 percent from any pass-through payment to a recalcitrant account holder or noncompliant foreign financial institution unless the foreign finan-cial institution has elected to be withheld upon.60 A non–financial foreign entity that does not indentify all its substantial U.S. owners or certify that it has no such owners will be subject to a 30-percent tax on the withholdable payments it receives.61 There is currently no mechanism for a non–financial foreign entity to withhold on payments made to a recalcitrant account holder in the case of less than flawless disclosure of its substantial U.S. owners.

Expanded affiliated group. A foreign financial in-stitution may have to enter into an agreement62 with the IRS for not only itself but for each member of its expanded affiliated group.63 A non–financial foreign entity does not have to enter into an agreement with IRS agreeing to comply with the requirements in new Code Sec. 1471(b).

Exemptions from reporting and withholding. The exemptions for reporting for foreign financial institutions and for exemption from withholding for non–financial foreign entities are different. For example, payments to a foreign publicly traded cor-poration or corporations in its expanded affiliated group will be exempt from non–financial foreign entity withholding and reporting under new Code Sec. 1472(c)(1)(A)–(B). A foreign publicly traded corporation may be a foreign financial institution subject to the reporting, verification and diligence requirements as well as pass-through withholding to recalcitrant account holders and noncompliant


September 2010

foreign financial institutions and itself subject to withholding under Code Sec. 1471(a) for noncom-pliance. A foreign pension plan may be a foreign financial institution unless excluded by the Treasury and could be a non–financial foreign entity since it is not excluded under Code Sec. 1472(c).

Elections to be exempt from FATCA—Bypassing the FFI agreement. A foreign financial institution may be able to make an election under new Code Sec. 1471(b)(2) as meeting the requirements for reporting (and pre-sumably withholding) if it complies with procedures to be prescribed by the IRS and otherwise satisfies any other requirements by the Treasury to ensure it does not have U.S. accounts. While a non–financial foreign entity can either disclose its substantial U.S. owners (generally those with more than 10-percent ownership by vote or value) or certify that it has no such owners, it cannot make this election.

Reason-to-know requirement. In addition, the withholding agent of a non–financial foreign entity

must not know or have reason to know that the infor-mation provided about the substantial U.S. owners is incorrect. 64 Withholding agents do not have to now have a similar requirement for the information obtained about U.S. accounts by foreign financial in-stitutions, regardless of whether the foreign financial institution directly withholds on any pass-through payments made to recalcitrant account holders or nonparticipating FFIs under new Code Sec. 1471(b)(1)(D), or whether the foreign financial institution makes an election to be withheld upon and pro-vide such information as may be necessary for the withholding agent to determine the amount of the withholding under new Code Sec. 1471(b)(3).

Shawn P. McKenna, a senior manager at Deloitte Tax LLP, recently put together as part of a draft article Table 1, which compares the impact of the new FATCA reporting and withholding rules for foreign financial institutions and non–financial foreign entities.65

FFI NFFEQualifying Entities Non-U.S. entities including banks, securities brokers

and dealers, hedge funds, private equity funds, CDOs, CLOs, family investment vehicles1 [unless otherwise exempted]

Any foreign entity that does not meet the FFI definition, such as operating businesses2 [unless otherwise exempted]

Income Subject to Withholding In general, withholdable payments include:• Any payment of interest (including any original

issue discount), dividends, rents, salaries, wages, annuities, and other fixed or determinable annual or periodical (FDAP) income, gains, and profits, if such payment is from sources within the United States

• Any gross proceeds from the sale of U.S. property of a type that can produce interest or dividends

• Interest paid by foreign branches of U.S. banks3• [portfolio interest unless exempted]

In general, withholdable payments include:• Any payment of interest (including

any original issue discount), divi-dends, rents, salaries, wages, annui-ties, and other fixed or determinable annual or periodical (FDAP) income, gains, and profits, if such payment is from sources within the United States

• Any gross proceeds from the sale of U.S. property of a type that can produce interest or dividends

• Interest paid by foreign branches of U.S. banks 4

• [portfolio interest unless exempted]

Withholding Rate 30%5 30%6

Waiver of Withholding on [Withholdable Payments]

Enter into [and complying with] a information report-ing agreement with U.S. Treasury (“FFI agreement”)7

Providing withholding agent with: cer-tification that entity does not have any substantial U.S. owners OR the name, address, and taxpayer identification number (TIN) of each substantial U.S. owners8

Who to report U.S. Account(s) to IRS9 Withholding agent10 [who provides to IRS]

Reduction of Withholding If no FFI agreement is entered into, the entire entity is withheld on.11

If a FFI agreement is in place, withholding is only required on the portion of non-U.S. entity’s specific owners, partners, shareholders, [debtholders,] trust-ees not in compliance with FFI agreement12 unless FFI elects to be withheld upon by withholding agent

None available. Entire non-U.S. entity is withheld on unless waiver of withhold-ing information is provided to withhold-ing agent13

Table 1.

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FFI NFFEAlternatives for Withholding Elect to be withheld upon by entity making withhold-

able payment14

None available

Types of Accounts Reported Any specified U.S. persons15

Depository accounts maintained by a natural person and whose aggregate balance is less than $50,000 across all accounts with the financial institution are exempt from reporting.16

Specified U.S. persons, directly or indi-rectly, owning [more than]:• 10% of corporation by vote or value• 10% of partnership by profits or capi-

tal interest• 10% of beneficial interest of such

trust

U.S. Account Information Reported • Name, address, and TIN of specified U.S. person. For U.S. owned foreign entities: name, address and TIN of each [more than] 10% owner per above, or 0%, as applicable

• Account number• Account balance or value• Gross receipts and gross withdrawals of payments

from account17 [if ] required by IRS

• Name, address and TIN of each [more than] 10% owner per above18

Alternatives for Reporting U.S. Account Information

Elect to be subject to full Form 1099 reporting for U.S. accounts19

None available

Specified U.S. Persons Included in Report-ing

Any U.S. person including:• Citizens or residents of the United Stateso Foreign persons holding green cards or meeting

substantial presence test are treated as U.S. resi-dents20

• Domestic partnerships• Domestic corporations• Any estate (other than foreign estates)• Any trust controlled by U.S. persons and able to be

administered by a U.S. court21

Any U.S. person including:• Citizens or Residents of the United

States• Foreign persons holding green cards

or meeting substantial presence test are treated as U.S. residents22

• Domestic partnerships• Domestic corporations• Any estate (other than foreign estates)• Any trust controlled by U.S. persons and

able to be administered by a U.S. court23

U.S. Accounts Exempt from Reporting and Exempt from inclusion as Specified U.S. Persons

• Any corporations regularly traded on an estab-lished securities market

• Any corporation where an affiliate that is regularly traded owns more than 50% of vote [and] value

• Certain tax exempt organizations and individual retirement plans

• Any U.S. agency• Any State, municipality, or U.S. possession• Any bank, REIT, RIC• Any common trust fund• Certain charitable trusts24

• Any corporations regularly traded on an established securities market

• Any corporation where an affiliate that is regularly traded owns more than 50% of vote [and] value

• Certain tax exempt organizations and individual retirement plans

• Any U.S. agency• Any State, municipality, or U.S. pos-

session• Any bank, REIT, RIC• Any common trust fund• Certain charitable trusts25

Foreign Accounts Exempt from Withhold-ing

Any payment beneficially owned by:• Foreign governments and their political subdivi-

sions or wholly owned agencies• Any international organization• Foreign central banks26

• Other classes of persons, identified by the Secre-tary, who pose a low risk of tax evasion27

Any payment beneficially owned by:• Foreign governments and their politi-

cal subdivisions or wholly owned agencies

• Any international organization• Foreign central banks28

• Other classes of persons, identified by the Secretary, who pose a low risk of tax evasion

• Corporations regularly traded on an established securities market

• Any corporation where an affiliate that is regularly traded more than 50% of vote [and] value

• Entities organized under the laws of a possession of the United States and owned by a bona fide resident29


September 2010

Comparison of Qualified Intermediary Rules to Foreign Financial Institution RulesAt a recent Executive Enterprise Institute Confer-ence, Chip Collins from UBS, Cyrus Daftary, from Burt Staples and Maner, LLP and Laurie Hatten-Boyd from KPMG LLP compared the differences between the qualified intermediary or QI rules and the new foreign financial institution rules.66

QI Member Status Is Elective—Conformity Rule for Foreign Financial Institutions

They noted that while QI status is purely elective, foreign financial institutions status applies to those entities that enter into a Code Sec. 1471(b) agree-ment with the IRS. An entity with a QI agreement must affirmatively invoke QI status with Form W8-IMY certifying QI status for identified accounts. If an affiliated group has a QI member, other

members may remain nonqualified intermediaries. Conversely, if a foreign financial institution enters into a section 1471(b) agreement with the IRS, that entity together with its expanded affiliated group as defined under new Code Sec. 1471(e)(2) will likely have to be parties to the agreement unless the Trea-sury provides exemptions under regulations.

QI Duties Limited to U.S. Source Income—Foreign Financial Institution Duties Broader for U.S. Accounts

In general, a QI’s compliance obligations relate only to accounts receiving U.S. source income (e.g., reportable amounts). A QI must disclose U.S. persons only if they receive U.S. source income (and possibly non-U.S. source income if paid inside the United States). A foreign financial institution must identify any U.S. account held by a specified U.S. person or U.S. owned foreign entity under new Code Sec. 1471(d)(1), including accounts receiving only non-U.S. source income.

FFI NFFEAbility to Combine Reporting

Refunds

Members of an expanded affiliated group where a common parent owns more than 50 percent of the vote and value may agree to combined reporting and enter into one FFI agreement.

Either all members of the expanded affiliated group need to participate in the election or none can par-ticipate30 except as otherwise provided by Treasury.

Requirement to identify substantial U.S. owners—No refund generally allowable unless the beneficial owner of the payment provide the IRS with informa-tion to determine whether the beneficial owner is a U.S. owned foreign entity and the identity of any substantial U.S. owners31

Special rule where FFI is beneficial owner of payment—refunds only generally allowed to FFI by treaty and no interest is allowed.32

None Available

Requirement to identify substantial U.S. owners—No refund generally allow-able unless the beneficial owner of the payment provide the IRS with informa-tion to determine whether the beneficial owner is a U.S. owned foreign entity and the identity of any substantial U.S. owners.33

1 Code Sec. 1471(d).2 Code Sec. 1472(d).3 Code Sec. 1473(1) separately excludes

income effectively connected with the conduct of a U.S. trade or business as a withholdable payment.

4 Id.5 Code Sec. 1471(a).6 Code Sec. 1472(a).7 Code Sec. 1471(b)(1).8 Code Sec. 1472(b)(1).9 Code Sec. 1471(b)(1)(C).10 Code Sec. 1472(b)(3).11 Code Sec. 1471(a).

12 Code Sec. 1471(b)(3).13 Code Sec. 1472(b).14 Code Sec. 1471(3) also requires your FFI

agreement to waive any US treaty protection on amounts withheld.

15 Code Sec. 1473(3).16 Code Sec. 1471(d)(1)(B) FFIs can elect to not

have this exemption apply.17 Code Sec. 1471(c).18 Code Sec. 1472(b)(1)(B).19 Code Sec. 1471(c)(2).20 Code Sec. 7701(b).21 Code Sec. 7701(a)(30).22 Code Sec. 7701(b).

23 Code Sec. 7701(a)(30).24 Many of these terms are further defined in Code

Sec.s provided under Code Sec. 1473(3).25 Id.26 Unless the foreign central bank is acting as

an intermediary for clients.27 Code Sec. 1471(f).28 Unless the foreign central bank is acting as

an intermediary for clients.29 Code Sec. 1472(c).30 Code Sec.1471(e).31 Code Sec. 1474(b)(3).32 Code Sec. 1474(b)(2).33 Code Sec. 1474(b)(3).

48


The foreign financial institution must then report this information to the IRS for such accounts un-der new Code Sec. 1471(b)(1)(C) and 1471(c) or close the account in the case of legal prohibitions to disclose the U.S. persons under new Code Sec. 1471(b)(1)(F)(ii).

QI Limited Withholding on Sales Proceeds—Foreign Financial Institution Withholding on Sales Proceeds for Recalcitrant Holders

Backup withholding is required for sales proceeds of U.S. securities only when a QI has actual knowledge that the account holder is a U.S. individual (e.g., nonexempt recipient) who refuses to be disclosed. A foreign financial institution must deduct and withhold a tax equal to 30 percent on any pass-thru payment which is made by such institution to a recalcitrant account holder or a noncompliant foreign financial institution under new Code Sec. 1471(b)(1)(D), un-less the foreign financial institution has elected to be withheld upon under new Code Sec. 1471(b)(3). For this purpose, a pass-thru payment will include with-holdable payments such as from the sale of U.S. stock or securities which are allocable to the accounts of held by recalcitrant account holders or noncompliant foreign financial institutions under new Code Sec. 1471(b)(3)(B).

Scope: Only Intermediaries for QIsIn order to have QI status, a financial institution must act as an intermediary. However, different agreements are available for transparent entities and certain trusts and partnerships. It is presently unclear under the foreign financial institution rules whether a sec-tion 1471(b) agreement will include nontransparent investment funds and other investment vehicles in addition to intermediaries and how entities which are disregarded under the check-the-box rules will be treated for purposes of FATCA.

At this same conference, John Staples,67 from Burt Staples & Manner, LLP, raised the following QI-specific issues: Will the QI agreement automatically be modified to include the foreign financial institution requirements? Can the IRS modify QI agreements on a different time-table than that which would apply to the nonqualified intermediary population? Will a QI agreement be modi-fied to eliminate the Form 1099 reporting obligations that can arise based upon “where payment is made” and “where sales are effected?” Are QIs subject to the

cost basis reporting rules only if they elect Form 1099 reporting in place of the foreign financial institution annual report required under new Code Sec. 1471(c)? What if QIs currently have segregated accounts with U.S. withholding agents and Form 1099-B reporting is currently being performed? Can FATCA result in less Form 1099 reporting—for example, a QI elects FFI reporting in place of current Form 1099 reporting?

QI Entities—Suggest Relieving QI Entities from 1099-B Reporting Requirements

The RBC Comments suggested that the Treasury consider relieving QIs of Form 1099-B reporting re-quirements because of resource constraints by many QIs with the following discussion:

We understand that at some point in the fu-ture, Treasury will introduce changes to the Ql Agreement to provide for the coordination of the provisions of Chapter 3 with the new provi-sions in Chapter 4. At that time, we suggest that consideration be given to amending the current definition of “reportable payments” contained in section 2.44 of the QI Agreement, to limit the Form 1099 reporting requirements of a non-U.S. payor QI to reportable amounts, as defined in section 2.43 of the Agreement. The current defini-tion of “reportable payments” makes reference to the regulations that address where payments are made and where sales are effected. These rules are vague and difficult to apply, particularly with respect to non-U.S. source payments.

Given the additional expectations being placed upon QIs and their affiliates under FATCA, the additional information reporting that will be provided for United States accounts, and the authority given to the Secretary under the FFI Agreement to request additional information with respect to United States accounts, it seems unnec-essary to retain the current reporting requirements as set out in the definition of reportable payments, particularly given that these requirements gener-ally apply in only very limited situations.

Relieving QIs of Form 1099-B reporting require-ments would also exclude them from the onerous cost basis reporting requirements that were recently enacted. Given the resources that QIs


September 2010

and their affiliates will expend to implement the FATCA requirements, we submit that it would be overly burdensome to also impose the cost basis reporting requirements upon them, particularly given the very small number of accounts that would be subject to the reporting obligations.

The RBC Comments68 explored in depth some of the problems relating to the implementation of the pass-through payment regime with the following analysis:

The definition of pass-thru payment should be clarified to apply only to limited situations where there is a reasonable concern steps are being taken to deliberately attempt to avoid withholding under Chapter 4 and there is a traceable link be-tween the account holder and the withholdable payment. Interest paid on deposit accounts or short-term investment certificates by a non-U.S. bank should not be considered to include any portion that is a U.S. source withholdable pay-ment or pass-thru payment, …

Similarly, U.S. source payments (e.g., U.S.-source pension payments) deposited into a client bank account outside the U.S. should not be viewed as pass-through payments subject to any withholding on the part of the receiving FFI if the account holder is recalcitrant. It should be the responsibility of the U.S. payor to determine the status of the beneficial owner of the payment, and withhold and report accordingly. The FFI is simply an agent receiving the payment on behalf of its account holder.

As a general rule, a portion of U.S. income or sales proceeds received by a foreign collective investment vehicle when distributed to an investor in a fund should not be defined to be a pass-thru payment. As was experienced with these types of payments under the QI Agreement, withholding on only a portion of a payment received or made creates significant operational challenges, and most often requires manual processing. For example, certain investment entities that are treated as flow-through entities for QI purposes (e.g., partnerships) make distributions throughout the year, but the allocation of the payment between U.S. source and non-U.S. source, and taxable or non-taxable is generally not available at the time of payment. Details of the composition of the payments are

generally not available until after year-end, at which time QIs often rely on manual processes to make adjustments to refund excess tax withheld throughout the year and to effect required U.S. tax reporting. Considerable effort is often required to gather such information. Similar challenges occur with distributions from U.S. mutual funds where a portion of distributions made throughout the year includes a non-taxable return of capital. It is very difficult and costly to implement systems changes that allow withholding to be taken on only a por-tion of a payment, particularly because that portion is frequently not determinable at the time of distri-bution. Given that the number of accounts that will be subject to the terms of FFI Agreements will be significantly more numerous than those under QI Agreements, reliance on manual processes needs to be avoided. The administrative cost and risk of error will be too high for larger FFIs.

There are other instruments which also cause sig-nificant challenges for QIs, including instruments that may be issued by a non-U.S. entity, but are deemed to pay U.S.-source income for U.S. tax purposes (e.g., dual-source securities). We are seeing an increasing number of such instruments, particularly in Canada. Most QIs find it necessary to implement manual procedures to review such pay-ments and make adjustments to take any additional U.S. withholding and to issue the appropriate re-porting after year-end. It is also a challenge for QIs to identify such instruments when they are initially acquired. We anticipate that a very small portion of new accounts will be recalcitrant. As such, we suggest that payments on these types of instruments should be excluded from the definitions of with-holdable and pass-through payments.

Audit ConsiderationsThe RBC Comments69 also raised several FATCA audit issues with the following discussion:

For large financial institutions with large numbers of clients, compliance will generally require highly automated procedures and processes. We recom-mend that the information that must be gathered to determine whether or not an account is a United States account be very clear, with no need for in-terpretation by the client or the employees of the FFI. Many products offered by FFIs are high volume

50


and “low touch”, and the client is often dealing with junior level staff who cannot be expected to understand or explain technical U.S. tax rules.

If the process is sufficiently integrated and im-bedded into routine procedures, there is low risk of significant non-compliance if policies and procedures are being followed and subsequent systems changes do not alter processing logic. For FFIs with large numbers of accounts and robust systems, we recommend that verification focus on actions taken by the FFI to implement policies, procedures and systems to achieve and maintain maximum compliance. Testing of actual accounts should be on an infrequent or exception basis.

We appreciate that developing detailed require-ments and regulations related to audit procedures may not be a current priority. However, it is important for FFIs to have a reasonable under-standing of the nature of the audit procedures that will apply if they enter into FFI agreements for purposes of assessing the cost and potential risks and exposure that may arise. In addition, as FFIs are making systems and procedural changes to comply with FFI agreements, it would be benefi-cial if Treasury and the IRS could identify specific due diligence procedures that might facilitate the subsequent verification process.

Exclusion of U.S. Branches and AgenciesAt least one commentator70 has raised the issue that guidance is needed to exempt the U.S. based branch or agency that is not within a separate U.S. entity from FATCA by providing the following analysis:

[C]ertain classes of FFIs may be treated as meeting the disclosure and reporting requirements of FAT-CA if the Treasury Secretary determines that the application of FATCA to the class is not necessary to carry out the purposes of FATCA. [Code] Sec. 1471(b)(2)(B). The Joint Committee on Taxation Technical Explanation of the HIRE Act provides some insight into how Congress intended the Treasury Department and IRS to implement this deemed compliance provision, stating:

‘[T]he Secretary may identify classes of institu-tions that are deemed to meet the requirements

of this provision if such institutions are subject to similar due diligence and reporting require-ments under other provisions in the Codes. Such institutions may include…certain U.S. branches of foreign financial institutions that are treated as U.S. payers under the present law.’71

It is our understanding that FATCA would not apply to the U.S. operations of an FFI if those operations are conducted through a subsidiary that is a sepa-rate entity organized in the United States, since the entity would not be a foreign entity. However, many FFIs conduct U.S. operations though a U.S. based branch or agency that is not within a separate U.S. entity. The financial services provided though such operations tend to be very specialized and limited in scope, and generally do not include taking FDIC-insured deposits or providing other U.S. retail banking services. Therefore, even in the absence of FATCA, the ability of U.S. citizens or residents to open accounts at these branches or agencies—for purposes of evading U.S. Federal income taxes or otherwise—does not exist as a practical matter. Stated differently, tax evasion-mined U.S. individu-als will not look to park their financial assets at a U.S. branch or agency of an FFI because the secrecy that they seek is totally unavailable.

Furthermore, and more pertinent to the legisla-tive history … , U.S. branches and agencies of FFIs already are generally subject to the same tax information reporting requirements and must comply with IRS information requests to the same extent, as U.S. financial institutions. For instance, the information reporting requirements for brokers ([Code] Sec. 6045), interest payments ([Code] Sec. 6049), dividend payments ([Code] Sec. 6042), and other transactions requiring the filing of Form 1099 or similar forms all apply to U.S. branches and agencies of FFIs, so the IRS has the ability to issue a third-party summons to such branches pursuant to [Code] Sec. 7602(b) and enforce the summons pursuant to [Code] Sec. 7604.

Even in the absence of the specific guidance concerning U.S. branches and agencies of FFIs provided in the legislative history … excluding these branches and agencies because of tax in-formation reporting and IRS information request compliance requirements that are comparable to those of U.S. financial institutions is permit-


September 2010

ted and supported by the statutory definition of a United States account” which excludes any account the holder of which is otherwise subject to information reporting requirements which the Treasury Secretary determines would make the reporting required by FATCA duplicative.

The RBC Comments72 also raised the issue that the definition of “withholdable payment” should be amended to exclude payments to a U.S. branch of a foreign bank with the following discussion:

In our view, it would be beneficial to limit the scope of the “withholdable payment” definition in the case of certain foreign entities that already have robust U.S. tax information reporting responsibili-ties, in order to reduce the potential for numerous additional FFI agreements and because there is a low risk of tax evasion. U.S. branches of foreign banks are treated as U.S. persons for most informa-tion withholding and reporting rules, and thus are required to fully comply with all U.S. information reporting and withholding laws and regulations. For example, U.S. branches of foreign banks must file IRS Forms 1099 with respect to payments to non-exempt recipients. In addition, they are subject to IRS audits. Consequently, they should be treated as U.S. withholding agents that are not FFIs for purposes of [Code] Sec. 1471 and 1472.

In addition to the fact that they must already comply with U.S. laws, branches (and agencies) of foreign banks conduct extensive operations in the United States and engage in hundreds of mil-lions of financial services and other transactions each year. Unless payments to such branches are treated as satisfying the FATCA requirements, each payor of a withholdable payment to such a branch would need to ensure that the bank has entered into an FFI agreement before making payments to the branch. Such a requirement would place U.S. branches of foreign banks at a competitive disadvantage compared to U.S. banks.

This exclusion is contemplated in the JCT Technical Explanation of the FATCA provision wherein it states: “Additionally, the Secretary may identify classes of institutions that are deemed to similar due diligence and reporting requirements under other provisions in the Code. Such institutions may include certain controlled foreign corporations owned by U.S. finan-

cial institutions and certain U.S. branches of foreign financial institutions that are treated as U.S. payors under present law.

Clarify Whose Treaty Rights Are Waived if Foreign Financial Institution Elects out of Withholding Responsibility

Code Sec. 1471(b)(3) permits a foreign financial in-stitution to enter into a agreement with the Treasury under which it would not perform the withholding, but would agree to provide sufficient information to the withholding agent or payor that makes a with-holdable payment to the foreign financial institution so that the withholding agent can determine how much of the payment is allocable to recalcitrant ac-count holders or nonparticipating foreign financial institutions and withhold on that portion of the pay-ment to the foreign financial; institution.

In addition to the electing foreign financial in-stitution providing sufficient information for the withholding agent to determine the proper amount to withhold from recalcitrant account holders and nonparticipating foreign financial institutions who have financial accounts with the foreign financial institution, the foreign financial institution will be required under Code Sec. 1471(b)(3)(C)(ii) to have to include in the agreement with the IRS a “waiver of any right under any treaty of the United States with respect to any amount deducted and withheld pursuant to an election …”

While there may be valid policy reasons to preclude a credit or refund to a recalcitrant account owner or nonparticipating foreign financial institution who has failed to provide the required U.S. account information to the electing foreign financial institution, it is firmly established under general U.S. tax treaty principles that another juridical entity cannot affirmatively waive another person’s rights under a U.S. tax treaty. Rather, such person must waive his or her own treaty rights in the manner and time prescribed by the Treasury. In this case, Code Sec. 1471(b)(3)(C)(ii) may be read to require a foreign financial institution who wants to elect out of its withholding responsibilities to be required to waive its own rights to a reduced rate of tax under a U.S. treaty and therefore a credit or refund otherwise available to it under Code Sec. 1474(b)(2)(A)(i)(I).

It is unclear if the drafters intended such a harsh result for the electing foreign financial institution who may want to be otherwise compliant with the reporting

52


requirements under Code Sec. 1471(b)(1)(A) and Code Sec. 1471(c), but who would prefer to put the withhold-ing responsibility with respect to its recalcitrant account holders and nonparticipating foreign financial institu-tions on the withholding agents who have resources and systems already in place to withhold such U.S. tax and deposit it on a timely basis with the IRS. If the Treasury concludes that the provision mandates that an foreign financial institution must enter into its own waiver to preclude it from claiming a reduced rate of tax under a U.S. treaty as a refund or credit then very few foreign financial institutions, if any, will decide to elect out of new Code Sec. 1471 withholding in favor of the with-holding agents who are much better suited to effectuate the required withholding under this new provision.

The Treasury may want to provide guidance to clarify whether the election is intended to require an electing foreign financial institution to provide its own waiver of any rights it may have under a U.S. treaty and thereby likely precluding an electing foreign financial institution from otherwise being entitled to a refund or credit under a treaty with the United States, or whether the provision should be read to require the electing foreign financial institution to obtain such waivers from the recalcitrant account holders or nonparticipating foreign financial institu-tions who have financial accounts with the electing foreign financial institution.

What if the NFFE Cannot Get the Reporting Information About Its Substantial U.S. Owners?It is likely that there will be many foreign structures in which foreign entities are owned by multiple tiers of other foreign entities that may have one or more sub-stantial U.S. owners based on the more-than-10-percent vote or value test, even though the reporting NFFE has no knowledge about such substantial U.S. owners. If the information about these substantial U.S. owners is not provided on a timely basis (or ever) because of foreign privacy laws, contractual privacy protections or otherwise what procedures can a non–financial foreign entity implement to be compliant under new Code Sec. 1472? At present, there is no mechanism for a non–financial foreign entity to withhold on re-calcitrant account holders or non-participating foreign entities who refuse to provide information about their accounts. Rather, the non–financial foreign entity must be withheld upon for any withholdable payments it receives under Code Sec. 1472(a).

FFI and NFFE Withholding and Refund Issues It may be helpful to go through a hypothetical to illustrate the possible application of the FATCA withholding and refund rules in the context of an investment entity which is a foreign corporation for U.S. tax purposes.

Assume the following facts: A non–publicly traded foreign investment entity is organized in a country that has a treaty with the U.S. that permits a reduced rate of withholding for U.S. source dividend and interest. The canton where the entity is located has a strict privacy law precluding debt and equity holders from divulg-ing any information about them and their accounts in the entity. In 2013, the investment entity entered into a Code Sec. 1471(b) agreement with the IRS to be treated as a participating FFI. The FFI will be treated as a corporation for U.S. tax purposes. As a means of obtaining working capital the foreign corporation is-sued a non–publicly traded zero coupon promissory note, which will paid at maturity to among other lend-ers, two debt holders who have refused to provide the information about their accounts (e.g., name, address, TIN, account number, etc.) that the FFI must obtain and report to the IRS.73 In addition, one U.S. individual shareholder who owns eight percent of the stock and has an 11-percent voting right has not responded to a notice requesting the U.S. account holders provide a valid and effective waiver of the canton’s privacy law.74 During the year, the FFI earned both U.S. and foreign source interest, dividends and capital gains from its global stock and securities investments, but decided because of the recession not to pay any dividends in 2013 and the foreseeable future.

Query, if the bank is the withholding agent, will it have a responsibility to withhold under FACTA? Presumably, the FFI is still compliant in 2013 under Code Sec. 1471(b) notwithstanding the fact that there are three recalcitrant account holders. Therefore, no withholding should be imposed in 2013 upon the withholdable payments attributable to the U.S. source FDAP income earned by the FFI or on the gross proceeds from the disposition of U.S. stock or securi-ties received by the FFI.75 However, the FFI may have to close the shareholder’s account if a valid privacy waiver is not obtained within a reasonable time.76

Unless the FFI makes an election to be withheld upon,77 rather than withholding on the pass-through payments made to the two recalcitrant debt holders and the recalcitrant shareholder the withholding


September 2010

responsibility, if any will fall upon the FFI for any pass-through payments made to these recalcitrant account holders.78 It should be noted under current law, the FFI does not have to obtain the consent of the bank to make this election, provided it gives the bank notice of the payment and provides such other information as is necessary for the withholding agent to determine the appropriate amount to withhold and include a waiver of any right under any treaty of the United States with respect to such amount withheld pursuant to the election.79 At this time, it is not clear whether the FFI or the recalcitrant account holders are required to waive their U.S. treaty rights under the new statute—presumably it is the later.80

If the bank is the payor because the FFI made the election to be withheld upon, or if the bank is the FFI (changing the facts somewhat)—what is the amount of the “pass-through payment” to the recalcitrant account holders? The term “pass-through payment” means “any withholdable payment or other payment to the extent attributable to a withholdable payment.”81 In this case, the OID on the promissory note will likely be treated as foreign source income.82 However, it is possible the IRS when it provides guidance will adopt a look-through rule approach following Subchapter K partnership principles or PFIC/CFC rules. Since the FFI received both U.S. source and foreign source income from its own trading activities which were in part fi-nanced through the proceeds from the promissory note and the shareholders equity investment, it is possible the IRS will provide guidance which allocates a portion of the FFI’s U.S. source income to each recalcitrant debt holders sufficient to at least equal to the amount of the annual OID or interest earned by each debt holder, and in some cases may include the gross proceeds paid on the retirement, sale or other disposition of the promis-sory note by the recalcitrant debt holders. Since the recalcitrant shareholder did not receive a dividend, and in any event, it would generally be treated as foreign source,83 one would think that there was no pass-through payment made to such shareholder. However, the IRS may provide guidance which allocates a portion of the FFI’s U.S. source income or gross proceeds from the sale of disposition of U.S. stock or securities to the recalcitrant shareholder notwithstanding these facts and create a deemed pass-through payment.

If the bank withholds on the pass-through pay-ments to the recalcitrant account holders, will these investors be able to obtain refunds, and can the bank in its capacity as the U.S. payor if the FFI makes the above election be withheld upon84 or can the FFI

obtain a refund on the investors’ behalf? Under the current law, there is no reclaim procedure for either the bank or the FFI to make an application for a refund or credit on behalf of its investors who have been withheld upon under FATCA. Rather, these investors will have to file their own timely claims for refund under new Code Sec. 1474 as if such withholding tax had been withheld under Chapter 3 (dealing with withholding of tax on nonresident aliens and foreign corporations)85 generally by filing a Form 1040NR or 1120F if they otherwise qualify as non-resident aliens or foreign corporations86 or generally a Form 1040 or 1120 if they are U.S. persons claiming a refund.

However, since the FFI failed to provide the re-quired information about the recalcitrant account holders (who will be treated as substantial U.S. owners of a U.S. owned foreign entity),87 no credit or refund will be allowed under new Code Sec. 1474(b)(3), unless the IRS provides guidance otherwise. As this time, it is not clear whether the recalcitrant ac-count holders who may have rights under an existing U.S. tax treaty to a refund or credit as is the case here will lose these rights under new Code Sec. 1474(b)(3), or whether this limitation only applies to the FFI and not to the recalcitrant account holders.

Special rule limiting FFI refund claims and interest. If the FFI was treated as the beneficial owner of a with-holdable payment (e.g., U.S. source FDAP income or gross proceeds from the sale of U.S. stock or securities) which the Bank withheld upon under new Code Sec. 1471(a) (e.g., the FFI failed to close the shareholder’s account or otherwise failed to satisfy the requirements in the Code Sec. 1471(b) agreement with the IRS and was treated by the IRS as noncompliant and presum-ably was required to notify the bank of this fact), new Code Sec. 1474(b)(2) imposes a special rule limiting the entitlement of the FFI to a refund only for a payment entitled to a reduced rate of tax by reason of a treaty obligation with the U.S. and no interest will be allowed with respect to such credit or refund.88

It is presently unclear whether testing for compli-ance under Code Sec. 1471(b) will be done on a year-by-year basis by the IRS (or other acceptable auditor) or on some other time period (e.g., every three years) and if an FFI is treated as noncompliant, whether the FFI will lose its refund rights retroactively or prospectively. It is also unclear how an FFI goes about curing such deficiencies with the IRS and if the FFI remediates the deficiencies will the IRS permit an FFI to obtain refunds relating to earlier noncompliant tax years.

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FATCA refund issues under U.S. tax treaties. Since a U.S. treaty may only apply to income or capital taxes or substantially similar taxes on income it is still an open question whether a noncompliant FFI or NFFE subject to tax imposed under new Code Sec. 1471(a) or 1472(a) will be within the taxes covered by a U.S. treaty, and therefore potentially subject to a reduced rate of tax under a U.S. treaty. In addition, since these FATCA provisions require a withholding agent to with-hold on the gross proceeds from the sale of U.S. stock or securities whether or not a taxable gain or loss is recognized by the noncompliant FFI or NFFE, even if this tax is within the scope of the taxes covered by a U.S. treaty, it is still an open question whether an FFI or NFFE will have a right to a reduced rate of tax under a U.S. treaty as the FATCA withholding may not be based on “gains” from the sale of personal property, Presumably, recalcitrant account holders who have been withheld upon under new Code Sec. 1471(b)(1)(D) or new Code Sec. 1471(b)(3) who are claiming a refund under a U.S. tax treaty will have the same issues as well absent guidance from the Treasury.

FATCA withholding agent exposure even if FFI has paid U.S. tax. If the bank withholds a 30-percent tax on withholdable payments made to an FFI because the FFI either failed to enter into FFI agreement or because the FFI is not compliant with such agreement to the satisfaction of the IRS, the fact that the FFI has no U.S. tax liability (e.g., the withholdable payment can be based on the gross proceeds from the sale or disposition of any property of a type which can produce interest or dividends from sources within the United States even if it is sold at a tax loss)89 is irrel-evant. Similarly, if the Bank withholds a 30-percent tax on pass-through payments either because the FFI has elected to be withheld upon, or because it is itself the FFI, the fact that the recalcitrant account holders do not have a U.S. tax liability is also irrelevant.

In this case, the U.S. withholding tax is in the nature of a penalty for noncompliance with the FATCA rules for U.S. accounts. Contrast this result with the with-holding regime under Chapter 3 (withholding tax on nonresident aliens and foreign corporations), Chapter 61 (Form 1099 reporting and backup withholding for U.S. persons) and Chapter 25 (federal income tax withholding), which generally permits a withholding agent to obtain relief from a withholding tax liability (excluding interest and penalties)—see Code Sec. 1463 for purposes of Chapter 3. In the case of FATCA, the withholding tax is a gross withholding tax which is in-tended to penalize FFIs and U.S. account holders who

are not compliant. Thus, unless the Treasury provides guidance which grants relief to a withholding agent, if a noncompliant FFI or recalcitrant account holder does not have a U.S. tax liability, the withholding agent will continue to be liable for U.S. withholding tax under new Code Sec. 1474(a).

NFFE considerations. Changing the fact some-what, if the bank is a withholding agent and makes payments to the same foreign corporation and such corporation is not treated as an FFI because it is engaged in other business activities and does not accept deposits, hold financial assets for the account of others or is engaged in the investment or trading in securities or other financial products,90 it will be treated as a NFFE.91

As such, the NFFE will be required to either certify that it does not have any beneficial owners who are substantial U.S. owners or report the name, address and TIN of each substantial U.S. owner, and have the withholding agent certify that that it does not know or have reason to know that any such information provided is incorrect.92

In this case, there are two debt holders and one equity holder that are noncompliant account holders. However, because a substantial U.S. owner must own more than 10 percent of the stock of the corporation (by vote or value)93 only the equity shareholder will likely be treated as a substantial United States owner because the shareholder owns more than 10 percent by vote or value (in this case, 11 percent by vote).94 If the NFFE does not obtain and report the required information about this shareholder after a reasonable inquiry, the statute directs the withholding agent to withhold a 30-percent tax on any withholdable payments received by the NFFE.95 Thus, any U.S. source FDAP income and the gross proceeds from the sale or disposition of U.S. stock or securities received by the NFFE (again, even at a tax loss) will likely be subject to this 30-percent tax. Unless the IRS provides guidance permitting either the withholding agent or the NFFE to withhold on the pass-through payments of a noncompliant account holder similar to Code Sec. 1471(b)(1)(D), withholding agent’s like the bank will have no choice but to with-hold to protect themselves from liability under Code Sec. 1474(a). The flush language of the statute indicates that the withholding agent will be “indemnified against the claims and demands of any person for the amount of any payments made in accordance with the provi-sions of [Chapter 4].”96

If Bank withholds on payments made to the NFFE, no credit or refund will be allowed or paid with


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respect to any tax withheld unless the beneficial owner of the payment provides the Treasury with the information it may require to determine whether such beneficial owner is a U.S. foreign entity97 and the identify of any substantial U.S. owners of such entity.98 Since the information about the shareholder has not been reported to the IRS presumably the NFFE has no entitlement to a refund or credit for such withheld tax. However, it is presently unclear whether the NFFE has a right under a U.S. treaty for a claim for refund as is the case here or whether this new provision can preempt pre-existing or new treaty rights.99

Similarly, if the bank withholds a 30-percent tax on withholdable payments made to the NFFE because the NFFE failed to satisfy the reporting requirements for sub-stantial U.S. owners or certify that it has no such owners, the fact that the NFFE or the substantial U.S. owners have paid their U.S. tax and have no liability is irrelevant as to whether the bank, in its capacity as a withholding agent must withhold to avoid liability for the Code Sec. 1472(a) tax under new Code Sec. 1474(a).

6038D reporting of FFI/NFFE interests by U.S. individuals. Beginning in 2011, individuals with any interest in a “specified foreign financial account” or “SFFA” must attach a statement to their 1040 if all such assets exceed $50,000.100 For this purpose, an SFFA will include any financial account,101 any stock or security issued by a person other than a U.S. person or any financial instrument or contract held for investment that has an issuer or counterparty which is other than a U.S. person and any interest in a foreign entity.102 Thus, the IRS will have a roadmap of an individual taxpayer’s U.S. accounts a full two years before FFIs and NFFEs have to commence reporting on these accounts, which presumably increases the stakes of failing to identify the U.S. accounts properly as of the general effective date of this legislation—January 1, 2013.103 See “Re-porting of Foreign Financial Assets.”

General ProvisionsConfidentialityNo person may use information under the new law except for the purpose of meeting any of its require-ments or for purposes permitted under Code Sec. 6103.104 However, the identity of foreign financial institutions that have entered into a Code Sec. 1471(b) agreement with the IRS is not treated as return infor-mation for purposes of Code Sec. 6103.105 The failure to comply with these confidentiality provisions of Code Sec 6103 can result in civil penalties.106

Account holder information is confidential. Under the new reporting tax regime, foreign financial institu-tions and each U.S. account holder and substantial U.S. owner and non–financial foreign entities will provide either a certification or detailed information about each substantial U.S. owner. While the identity of the foreign financial institutions and presumably its affiliates will be publicly available information, com-mentators have recommended that all account holder information derived by foreign financial institutions as part of their responsibilities under the section 1471(b) agreement or by non–financial foreign entities as part of the certification or disclosure process be subject to the full confidentiality protections of Title 26 (e.g., Code Sec. 6103). It is also unclear whether the identity of non–financial foreign entities will be able to be disclosed by the IRS under new Code Sec. 1474(c).

Truncation should be required for FATCA payee statements furnished electronically. Notice 2009-93107 issued on November 19, 2009, created a pilot program that permits filers of certain information returns (forms in series 1098, 1099 and 5498) to truncate individual identification numbers on paper (but not electronic) payee statements as a means to curb misuse and mis-appropriation of individual tax identification numbers and identity theft. Under the pilot program, the IRS will permit a taxpayer’s TIN to be truncated by replacing the first five of the nine digit number with asterisks (***-**) or X’s on payer payee statements.

On July 22, 2010, the ABA Tax Section submitted Comments on Notice 2009-93 Concerning the Pilot Program to Truncate Taxpayer Identification Numbers on Certain Payee Statements,108 and recommended among other comments that truncation should be required for payee statements furnished electronically with the following discussion:

The delivery of payee statements electronically does not necessarily reduce the rates of non-delivery and misappropriation of TINs; therefore, the Notice should be expanded to include electronic payee statements as well. Requir-ing truncation for electronic statements would help to ensure that TINs are not inadvertently disclosed by filers to unauthorized third-parties while attempting to comply with information reporting requirements.

Electronic receipt of information statements by payees typically involves delivery by way of electronic mail (“email”) or by the download-

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ing of information through a payor’s website. Delivery of statements by either manner is inherently insecure. Incidents of hacking, spoof-ing, insecure connections, open Wi-Fi (wireless internet connections that are susceptible to radio interception), computer viruses designed to steal information, malware (malicious software that is used to control a person’s computer), web browser history misuse and other problems in security are common. There have even been re-ported incidents of hacking by organized crime syndicates and unfriendly governments.

Not only should truncation of TINs be permitted on payee statements that are delivered elec-tronically, but truncation should be required. If truncation of TINs is merely permitted rather than required in the case of electronic delivery of return information, we believe that many filers will disregard truncation and the goal of the Ser-vice to reduce TIN misuse will not be furthered. Therefore, final rules on the truncation of TINs should require the truncation of TINs on both paper and electronic payee statements.

Coordination with Other Withholding ProvisionsThe Treasury will provide for coordination of new Chapter 4 with other withholding provisions, includ-ing providing for the proper crediting of amounts deducted and withheld under the new law against amounts required to be deducted and withheld un-der other provisions of the Code.109 Presumably, this provision was broadened in the new law in response to the SIFMA Comments and others that the FATCA Bill’s coordination provisions were too narrow.110 See “SIFMA Comments for Coordination with Other Withholding and Information Reporting Provisions” below. The Treasury may provide further coordinating rules to prevent double withholding, including in situ-ations involving tiered U.S. withholding agents.111

SIFMA Comments for coordination with other withholding and information reporting provisions. The SIFMA Comments to the proposed FATCA legisla-tion recommended that the provisions be coordinated with other withholding and information reporting provisions by stating:112

Although the Bill provides appropriate language with respect to the existing withholding provisions of Code Sec. 1441 (withholding tax on nonresi-

dent aliens) and Code Sec. 1445 (withholding tax on dispositions of U.S. real property interests), ad-ditional coordination language should be added with respect to other sections, including but not limited to Code Sec. 1442 (withholding tax on foreign corporations), Code Sec. 1446 (withhold-ing tax on foreign partners’ share of effectively connected income), Code Sec. 3402 (wage with-holding), Code Sec. 3405 (withholding tax on pension, annuities, and other deferred income), Code Sec. 3406 (backup withholding tax), and Code Sec. 4371 (foreign insurance excise tax).

In addition, the Bill should provide the appropri-ate coordination language with respect to existing reporting provisions, including but not limited to Code Sec. 6041 (information at the source), Code Sec. 6041(A) (returns regarding payments of remu-neration for services and direct sales), Code Sec. 6042 (returns regarding payment of dividends), Code Sec. 6045 (returns of brokers), and Code Sec. 6049 (returns regarding payment of interest).

Authority to Prescribe RegulationsThe U.S. Treasury has been specifically granted the au-thority to prescribe such regulations or other guidance as may be necessary or appropriate to carry out the pur-pose of the new law.113 The ABA Tax Section Comments to the proposed FATCA legislation specifically requested that the Treasury be granted broad authority under the new tax reporting and withholding regime by stating:114 “We recommend that the Bill authorize Treasury to pro-vide workable guidelines for FFIs to follow regarding the information-gathering and reporting obligations, data measurement, disclosure, account holder monitoring, verification and error correction that, if followed, would be deemed satisfactory compliance.”

Effective Date and Grandfather Treatment for Outstanding Obligations

The new law applies to payments made after Decem-ber 31, 2012.115 However, the law does not require any amount to be deducted or withheld from any payment under any obligation outstanding on March 18, 2012, the date that is two years after the date of enactment or from the gross proceeds from the sale or disposition of such obligations.116 Unless the grand-father provision is read very broadly, most historical U.S. accounts will be subject to the new diligence, verification, reporting and withholding regime for


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payments made with respect to such accounts after December 31, 2012. See “U.S. Account” and “U.S. owned foreign entity.” It is likely this date is overly optimistic since there are significant issues for the implementation of the new information reporting and withholding system—the original qualified intermedi-ary took over six years to implement and its effective date was delayed several times.

The grandfather provision no longer requires the terms of a debt obligation that is registered for tax purposes to include a gross-up provision that would be triggered as a result of enactment of the new law.117 While the term “obligation” is not defined in the new law or leg-islative history; presumably, the grandfather provision extends to both short- and long-term obligations, as well as registered and unregistered debt obligations. It is also presently unclear whether the grandfather provision will apply to stock or other equity instru-ments (e.g., qualified and nonqualified stock options, stock appreciation rights, restricted stock units, etc.).118 Notice 97-34119 dealing with information reporting on transactions with foreign trusts and on large foreign gifts defined the term “obligation” to include “… any bond, note, debenture, certificate, bill receivable, ac-count receivable, note receivable, open account, or other evidence of indebtedness, and to the extent not previously described any annuity contract.”

Query, if an obligation is exempt from withholding under new Code Sec. 1471(a) under the grandfather provision, will pass-thru payments which are made to recalcitrant account holders or noncompliant foreign financial institutions under new Code Sec. 1471(b)(1)(D) be subject withholding or will these payments also be exempt based on the rationale that the for-eign financial institution is itself is exempt under the grandfather exception?

Application of material modification rules. It is anticipated that the Treasury may provide guidance as to the application of the material modification rules under Code Sec. 1001 in determining whether an obligation is considered to be outstanding on the date that is two years after the date of enactment and how to treat nontaxable refinancing or recapi-talizations.120

Delay effective date to permit the Treasury to promulgate rules for implementation of the new reporting and withholding regime. Several commen-tators to the FATCA legislation recommended at least an 18-to-24-month implementation period to ensure full and robust compliance by foreign financial insti-tutions and non–financial foreign entities.

FATCA’s effective date had permitted a one-year implementation period and generally applied to payments made after December 31, 2010.121 Under a grandfather rule, the proposed withholding and reporting provisions would not have applied to any obligation outstanding on the date of the first com-mittee action, if such obligation was in bearer form or if the obligation includes (on the date of the issu-ance of such obligation) a provision under which the issuer would (but for this provision) be obligated to make additional payments under such obligation by reason of the provision.122

Even though the reporting and withholding provisions under new law were extended for two years and will be generally applied to payments made after December 31, 2012, the new law may nonetheless presents severe administrative challenges for both foreign financial in-stitutions and non–financial foreign entities. Under the new law, foreign financial institutions will have to enter into a section 1471(b) agreement with the IRS to avoid the 30-percent withholding tax, while non–financial foreign entities must provide information about their substantial U.S. owners.

At least one Tax Director at a large foreign bank indi-cated that it is critical that foreign financial institutions develop an automated process that can handle the transaction volume without a significant error rate. The law as now written contemplates a a low tolerance for errors which is not a likely outcome or realistic prob-ability given the high volume of transactions subject to the new reporting and withholding regime.

Several commentators have recommended that the law authorize the Treasury to provide guidance which will address the rules foreign financial institutions must follow including details on the information-gathering and reporting obligations, data measurement, dis-closure, account holder monitoring, verification and other requirements foreign financial institutions must follow for error correction, withholding and refunds.

NYSBA Tax Section Comments—Effective date flexibility. The NYSBA Tax Section Comments strongly advocated permitting the Treasury to have the flexibility to extend the effective date of the new law by stating:123

Financial entities and non-financial entities will need time to implement the requirements im-posed by Code Sec. 1471-1474. Many of these requirements will be set forth in the regulations, which may not be available immediately. Given the complexity and delicacy of the task, those

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regulations will take time to draft and will need to be fully vetted when released in proposed form (likely more than once). After the substance of the rules is available, implementation of the necessary compliance systems will take considerable effort, and some requirements may take financial entities and the IRS longer to implement than others.

We appreciate that the [Extender’s Act] has deferred the effective date of these provisions to December 12, 2012, but we strongly recommend that the Treasury Department have the express authoriza-tion to extend the effective date, in whole or part, as it deems necessary or appropriate. To this end, the legislative history should acknowledge the significant amount of time that will be required for the Treasury Department to issue the necessary extensive guidance implementing the rules under Chapter 4 and the time the financial services indus-try will need to understand the rules and prepare procedures and systems in order to comply with the rules. This flexibility will give the Treasury De-partment time to prepare the necessary guidance, which it may decide to phase in over time, and will give the financial services industry time to prepare for compliance and for a critical mass of section 1471(b) agreements to be signed.

Proposed Code Sec. 1474(d)(2) would grandfather “any amount to be deducted or withheld from any payment under any obligation outstanding” on the date two years after the date of the enactment of the [Extender’s Act]. The legislation is ambiguous in two important ways: first, it should clarify what is intended to be covered by the statutory term “obligation”. In particular, it is not clear whether only debt obligations would constitute an “obli-gation” for this purpose or whether contractual obligations (like licenses or annuities) or equity securities would constitute “obligations” subject to grandfathering. We would recommend that, except as provided in regulations, the term “obli-gation” should include all contractual obligations (debt and other contractual obligations such as licenses and annuities) but should exclude equity securities. Second, we strongly recommend that the legislation clarify that a “payment under any obligation” under Sec. 1474(d)(2) includes any payments of proceeds from the sale, redemption or other disposition of any obligation. Without greater clarity on the precise nature of which payments and

which obligations are to be grandfathered under proposed Code Sec.. 1474(d)(2), we are concerned that the grandfathering provision may not be fully effective in avoiding market disruption during the period that the precise requirements under [the Ex-tender’s Act] are being developed. In the absence of clarification, issuers and investors would not know whether or not they are subject to these rules. Ac-cordingly, we strongly recommend that Congress revise the language of proposed Code Sec. 1474(d)(2) to clarify the definition of an “obligation” and to explicitly provide that payments of proceeds on the sale, redemption or other disposition of an obligation are included as grandfathered payments under Code Sec. 1474(d)(2).

In addition, we would recommend that the two-year grandfathering provision apply to any “obligation” issued pursuant to a commitment undertaken by the issuer of the obligation, or an option granted to the issuer by the lender/holder/counterparty of the issuer, during the two-year pe-riod. We are concerned that grandfathering only obligations outstanding during that period may inadvertently make it difficult for U.S. borrowers to obtain, during the two-year period, revolving credit facilities, loan commitments (e.g., loans that can be drawn only after certain benchmarks are met, rather than by a date certain), and stand-by credit facilities and letters of credit.

EBF FATCA Comments—Effective date. The EBF FATCA Comments helpfully address many of the needed steps both Treasury and foreign financial institutions will have to go through before they can implement the new reporting and withhold-ing regime:124

We recommend that new Chapter 4 (Code Sec. 1471—1474) should be effective only when and to the extent provided in Treasury regulations. We understand that Congress may wish to express in legislative history an appropriate timetable for the Treasury Department to issue any such implementing regulations. In addition, it would be helpful if the legislative history encourages the Treasury Department to adopt regulatory effec-tive dates that will allow for an orderly transition by the financial industry and the IRS to the new withholding tax regime envisioned by Chapter 4 after final regulations are issued.


September 2010

In particular, the legislative history should clarify that Congress anticipates that Treasury will adopt effective dates that enable financial institutions to put in place, or adapt, automated systems to effectuate the new rules, and to train personnel in applying the new rules. Likewise, the legislative history should encourage the Treasury Depart-ment to consider the time necessary for the IRS to publish a form of agreement with foreign financial institutions under Section 1471(b) and to finalize such agreement; to sign up those FFIs deciding to enter into such agreements and to publish a list of such qualifying FFIs; to revise Forms W-8 to better collect data related to the new rules; and to put in place streamlined refund and credit processes for any over-withholding that results from the new rules. (Based upon the financial industry’s experi-ence with the implementation of the QI regime, we believe it likely that three years from the time the implementing regulations are finalized will be required to accomplish the above tasks.)

Rationale. Proposed Code Sec. 1474(d)(1) pro-vides that new Chapter 4 will generally apply to payments made after December 31, 2010 [extended to December 31, 2012 under the new law]. Chapter 4, however, simply sets forth a framework that requires extensive guidance by the Treasury Department before it can be implemented, and grants to Treasury substantial flexibility in issuing regulations detailing how those rules will work in practice.

We support the approach of providing Treasury with the flexibility to work with the financial industry and the IRS to find an appropriate balance between the compliance goal of the Bill to combat U.S. tax evasion and the inevitable costs and burdens as-sociated with that goal. Such a balancing effort is crucial in order to try to minimize the disruptions to the U.S. capital markets if a critical number of FFIs were not to “buy in” to the new regime because the costs and risks associated with FFI status were disproportionate to the compliance goal.

We believe that the sort of flexible approach envi-sioned by the Bill necessarily calls for an effective date that is tied to the issuance of regulations and a sufficient time period to permit their orderly imple-mentation by the financial industry. No FFI will be in the position to determine if it should sign an FFI

agreement without understanding what costs and risks are associated with that agreement as detailed in the implementing regulations. Furthermore, a failure to provide sufficient time for the financial industry to build the systems and processes to comply with any final regulations could lead to massive amounts of over-withholding, contrary to the intent of the Bill. Accordingly we strongly urge Congress to provide the Treasury Department with the authority to design an appropriate timetable for implementation and not tie its hands with a statu-tory effective date as of a date-certain.

ABA Tax Section Comments to delay effective date to permit guidance and implementation of new reporting and withholding regime. The ABA Tax Section Comments to the proposed FATCA legislation also addressed extending the effective date of the proposed legislation by stating125:

The section 101 effective date generally only permits a one-year implementation period and will strain the administrative capabilities of FFIs. We recommend that the provisions not be effec-tive prior to such time as Treasury may determine is reasonable to permit compliance by FFIs and NFFEs, which may be two or more years follow-ing enactment.

Under the Bill, FFIs would have to enter into an agreement with the IRS to avoid the 30 percent withholding tax and would have to collect account information not only for its own accountholders and non-regularly traded equity and debt holders but for those of its 50 percent affiliates. In practice, whether entering into a section 1471(b) agreement would be acceptable to an FFI would depend on the particular requirements underlying the section 1471(b) obligation. The Bill offers little guidance on the extent of the obligations, including the fre-quency of measurement of the financial data, and the extent of verification procedures required. It is critical that this guidance be made available for FFIs to decide whether to change their systems to continue to invest in U.S. securities, and if so, to allow the time to do so before any effective date.

Section 101 of the Bill is intended to promote compliance by U.S. persons and to obtain in-formation, not to result in a large of withholding tax or frighten investors or intermediaries from

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U.S. markets. In order that this may occur, it is essential that FFIs are confident that they can de-velop processes to handle the transaction volume without a significant error rate.

SIFMA Tax Comments requesting a delay of the ef-fective date. SIFMA also commented upon delaying the effective date for the proposed FATCA legislation by stating, in part:126

The Bill would require an unprecedented level of U.S. tax information gathering and reporting by foreign entities that have not traditionally en-gaged in such efforts. Even for a seasoned U.S. financial institution, expanding existing U.S. tax information reporting systems to satisfy the re-quirements of the Bill would be time consuming and expensive. For an FFI that has no existing U.S. tax information reporting systems, complying with the requirements of the Bill will be a monumental task, which will require hiring numerous addi-tional employees, the creation of new information technology systems, and the training of large numbers of current workers. The ability of FFIs to engage in such efforts on a short time frame (or indeed, at all) cannot be presumed.

EBF/IIB Comments on effective date. The EBF/IIB had the following comments regarding the FATCA effective date provision and future phase in dates:

… the guidance that is provided on a priority basis regarding the identification of U.S. accounts and related due diligence should stratify the population of business lines and existing accounts based on the likely risk of U.S. tax avoidance and burdensome-ness of implementation, and should provide for extended, phased-in effective dates for those cat-egories that are less likely to present a high risk of U.S. tax avoidance and/or raise serious implemen-tation burdens. For example, we would expect that private banking and custodial securities investment accounts would have a higher priority than retail banking, and FFIs might prioritize their attention on such business lines first. Similarly, as discussed above, we believe that FFIs will need considerably more time to identify U.S. owners of entities than direct account holders. In this regard, the govern-ment should specify what expectations it has for the financial community as of FATCA’s effective date of January 1, 2013 and as of future phase-in dates.

In addition to clear phase-in rules for various cat-egories of business lines and accounts, we would also ask that Treasury and the IRS provide a sort of general safe harbor for “good citizen” institutions that make reasonable efforts to comply in time for 2013, even if not all systems are up and running because of the magnitude of the technological, procedural, control and training tasks presented by FATCA. We make these requests because we read the statute as immediately effective for payments made after December 31, 2012 with the exception of grandfathered securities, and we remain quite concerned that the financial community will be faced with the daunting task of trying to implement a comprehensive withholding tax regime within a potentially unrealistic time frame if regulations are not finalized fairly quickly.

Comments on Successful Implementation of Chapter 4 In Announcement 2010-22, the Treasury requested comments from taxpayers on Subtitle A of Title V of the HIRE Act entitled “Foreign Account Tax Compliance.” The successful implementation of the new disclosure, reporting and withholding regime will require guid-ance from industry to the Treasury, together with and prudent and carefully drafted rule-making and other guidance by the government which will address among other issues: (1) coordination between reporting and withholding system for foreign financial institutions (new Code Sec. 1471) and non–financial foreign enti-ties (new Code Sec. 1472); (2) coordination between the existing nonresident withholding and qualified intermediary reporting rules (Code Secs. 1441–1446) and the new regime (new Code Secs. 1471–1474); (3) proper crediting and amounts deducted and with-held under the HIRE Act against amounts required to be deducted and withheld under other tax rules; (4) coordination between the Chapter 3 and new Chapter 4 refund systems; (5) the recordkeeping and verification requirements to satisfy the section 1471(b) or FFI agreement; (6) rules which address the new information reporting requirements and exclusions or exceptions; (7) rules which address inadvertent mistakes or footfalls by foreign financial institutions and non–financial foreign entities or withholding agents and other U.S. payors and tolerance limits for mistakes; (8) rules that address the status of payees; (9) rules which address direct and indirect ownership of entities; (10) anti-abuse rules; (11) rules which address


September 2010

treaty compliance including required documentation and certifications; (12) procedural issues and the ap-plication of the extended statute of limitations; (13) addressing the new penalty provisions; (14) granting appropriate extensions of time as necessary to imple-ment the new regime properly (15) rules that address privacy waivers and closing the accounts, if necessary, and (16) rules that address the use of statistical sam-pling techniques to identify U.S. accounts.

Prioritization Issues

The EBF/IIB Comments127 have helpfully suggested to the Treasury that they focus on the following pri-orities as it decides on what guidance to provide to taxpayers:

Implementation of FATCA on a timely basis will be a monumental task for both the government and the financial community. As we have previously noted, the financial community will likely need at least two years from the issuance of comprehen-sive and final guidance to set up the systems and perform the due diligence to be able to comply with FATCA. It is desirable and tempting to talk about prioritizing the guidance, so that the finan-cial community has more time to put in place those items that will require more time to implement. Unfortunately, however, so much of the guidance is necessarily and integrally interrelated, and thus it is unlikely to be practical for the financial com-munity to begin to create new systems, begin due diligence or train personnel until a substantial portion of the guidance is finalized. Nonetheless, we provide the following suggestions regarding the overall guidance project and its prioritization.

[I]n terms of prioritization, it will be very helpful for the IRS at an early point in time to (i) indicate the overall architecture of the new regime it proposes to implement, focusing on the categories of FFIs (e.g., those that must enter into FFI agreements under section 1471(b), and those that will be eli-gible for alternative rules, such as the FFE and SFIE approaches that we propose herein, or that will be exempt altogether), and (ii) provide detailed guid-ance regarding what FFIs will be expected to do regarding the identification of U.S. accounts in the case of both existing and new accounts (i.e., the issues discussed in Paragraph 2 above). This guid-ance should be sufficiently precise so that FFIs can

begin to set up their identification and due diligence systems. the EBF and IIB are concerned that Trea-sury and the IRS may view their immediate task as limited to publishing first proposed and then final regulations. However, we believe that substantial guidance in addition to the admittedly vital regu-lations are crucial if the FATCA withholding tax system is to operate reasonably well. We respect-fully request that these items be published in draft form so that the financial community can provide comments to you to make the items more useful to the IRS and less burdensome to the industry. Specifi-cally, we request that the IRS complete action on the following items by the end of 2010:

A new Form W-8BEN for individuals that allows the beneficial owner to certify to non-U.S. tax status and that provides more relevant indicia of U.S. tax status through certifications related to such status (e.g., dual citizenship, place of birth, green card status, substantial presence, etc.). We believe that in conjunction with this change in the Form W-8BEN, the section 1441 regulation re-quiring a “reasonable explanation” in writing for a U.S. address be eliminated. The rule is largely meaningless in effect and the government’s con-cerns regarding U.S. tax status should be more directly addressed by the Form

A new Form W-8BEN for entities (including a checkbox that would enable the entity to certify its nature for U.S. tax purposes, that it does not have substantial U.S. owners and/or that it satisfies an exception to NFFE status, and a way for an NFFE to provide information about its U.S. owners). It should also allow an FFI acting with regard to its own ac-count to certify if is a participating FFI or not. We urge the IRS to issue clear and detailed instructions in connection with such a new Form W-8BEN to help entities determine both the U.S. tax classifica-tion of their particular entity and how to determine and measure substantial U.S. ownership.

Sample formats or an official form for an NFFE to provide information regarding substantial U.S. owners in the event that a Form W-8BEN cannot be collected. A new Form W-8IMY that includes a way: (1) for an FFI to certify if it is a “participating” FFI (that is, one that has an agreement with the IRS); (2) for an FFI to elect to have another with-

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holding agent do the Chapter 4 withholding on any recalcitrant account holders and provide allocation information to accomplish this end; (3) for an FFI-type entity to certify that it should be treated as an FFE; and (4) for an FFI or an FFE to certify that it has no U.S. customers. The FFI Agreement and instructions on how to file it. It will be quite key that FFIs and FFEs under-stand any proposed audit requirements as soon as possible so that they can complete the cost/benefit analyses that will be necessary to ensure that being a participating FFI or FFE is commercially feasible. Forms (or amended versions of existing forms) for reporting taxes withheld under FATCA, as well as a revenue procedure or other guidance describing how taxes withheld under FATCA should be deposited. Sample formats (for electronic filing) or an of-ficial form for the FFI annual report regarding its U.S. customers. Sample formats (for electronic filing) or an of-ficial form for the U.S. account holder reports required under FATCA for FFEs

A revenue procedure or other guidance describ-ing how a beneficial owner can establish that it is entitled to a refund of tax withheld under FATCA. As discussed above, it is particularly crucial that a robust refund mechanism be instituted, especially since gross proceeds will also be subject to with-holding for the first time. The new requirements are likely to be relatively unknown to many FFIs, FFEs and NFFEs, particularly smaller entities.

A web site listing (1) all participating FFIs and those deemed by the IRS to be non-participat-ing FFIs, (2) those FFI-type entities electing FFE status, (3) FFEs that the IRS determines are non-participating FFEs, and (4) electing 1471(b)(2) FFIs (i.e., those without U.S. cus-tomers). We recommend that the IRS commit to updating this web site on a monthly basis so that withholding agents can code their systems with more accurate data. The EBF and IIB believe that FATCA’s effective date should be delayed until at least 18 - 24 months after all of these items are published so that systems and procedures can be developed to accommodate the new requirements. At a

minimum, the IRS should provide that no with-holding liability or penalties will be imposed for failure to comply with FATCA before that date.

Reporting of Foreign Financial AssetsIncome Tax Return Reporting for Foreign Financial AssetsA U.S. person who transfers assets to and hold inter-ests in foreign bank accounts or foreign entities may be subject to self reporting requirements under both Title 26 (the Internal Revenue Code) and Title 31 (the Bank Secrecy Act) of the U.S. Code. Under current law, Treasury Department Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (the FBAR), must be filed by June 30 of the year following the year in which the $10,000 filing threshold is met.128

More specifically, an FBAR is required if the follow-ing conditions are met: (1) the filer must be a U.S. person; (2) the filer must have financial account(s); (3) the financial account must be in a foreign coun-try; (4) the filer must have a financial interest in the account or signature authority over the foreign financial account; and (5) the aggregate amounts in the accounts valued in dollars must exceed $10,000 at any time during the calendar year.129 A financial interest includes an account held by an entity where a U.S. person directly or indirectly owns more than 50 percent of the corporation or partnership, or has a beneficial interest in over 50 percent of the assets or income of a trust that owns a non-U.S. account. It should be noted the new tax return reporting re-quirements discussed below are not intended as a substitute for compliance with the FBAR reporting re-quirements, which are unchanged by the new law.

Under the new law (which is the same was in the Extenders Act), if an individual holds any interest in a “specified foreign financial asset,” or “SFFA,” he will be required to attach to his tax return an an-nual disclosure statement declaring the asset and certain other “6038D required information,” if the aggregate value of all such assets exceeds $50,000 (or any higher amount prescribed by the IRS) at any time during his tax year.130 The term “specified foreign financial asset” or “SFFA” means131:

any “financial account” maintained by a foreign financial institution (including any non–publicly traded equity and debt of a foreign financial institution, and


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any of the following assets that are not held in an account maintained by a foreign financial institu-tion including (i) any stock or security issued by a person other than a U.S. person, (ii) any financial instrument or contract held for investment that has an issuer or counterparty that is other than a U.S. person, and (iii) any interest in a foreign entity.

An individual is not now required under these new rules to disclose foreign interests that are held through a U.S. financial institution. At present, it is not clear how or when a taxpayer is supposed to calculate the “aggregate value.” Query, is this amount based on gross assets or net assets? For an explanation of financial ac-count and foreign financial institution, see “Financial Account” and “Foreign Financial Institution.” Since the new reporting requirements are not the same as the FBAR reporting requirements, individuals would be wise to review any “foreign accounts” or interests in foreign entities to ensure the proper U.S. tax reporting is done to avoid penalties under either the FBAR regime or the new reporting regime. See “Liability for Withholding Tax, Interest, Penalties and Statute of Limitations.”

Information required to be attached to return. Although the nature of the information required is similar is to the information disclosed on an FBAR, it is not identical. For example, a beneficiary of a foreign trust who is not within the scope of the FBAR reporting requirements because his interest is less than 50 percent may nonetheless be required to dis-close the interest in the trust with his tax return under this provision if the value of the threshold is met.

The information to be included on the statement includes identifying information on each asset and its maximum value during the tax year. In the case of an account the information to be attached to an indi-vidual’s tax return with respect to any such asset is the name and address of the financial institution in which such account is maintained and the account number of such account. In the case of any stock or security, the name and address of the issuer and such information as is necessary to identify the terms and class or issue of which such stock or security is a part. In the case of any other instrument, contract or interest such information as is necessary to identify the instrument, contract or interest, the nature or terms of such instrument, contract or interest, the names and addresses of all issuers and counterparties with respect to such instrument, contract or interest. In each case the maximum value of the asset during the year must be disclosed.132

One commentator133 has suggested that clarity is needed for the phrase, “any financial instrument or

contract,” and asks what does this definition include? Among other questions this commentator asks is whether this will require reporting for (i) foreign social security programs, (ii) private pension funds, (iii) private life insurance contracts, (iv) mortgages, (v) futures, options and derivatives, and (vi) other con-tracts. 134 Presumably, even foreign real estate and art work purchased through a foreign entity will have to be reported. It is not clear whether the IRS will issue a new form for the disclosure or whether a taxpayer can simply attach a statement to his or her tax return (Form 1040) or whether the Form 8275 (the general disclosure statement) should be used.

An individual is not required to disclose interests that are held in custodial account with a U.S. fi-nancial institution, nor is an individual required to identify separately any stock, security, instrument, contract or interest in a foreign financial account disclosed under this provision. Under the new law, the Secretary is permitted to issue regulations that would apply these reporting obligations to a domestic entity in the same manner as if such entity were an individual if that domestic entity is formed of to hold such interests directly or indirectly. See “Penalty for Failure to Disclose Foreign Financial Assets.”

The Secretary is directed to prescribe guidance to carry out the purposes of this provision and to provide appro-priate exceptions from its application for classes of assets that would be duplicative of other disclosures, nonresi-dent aliens and bona fide residents of U.S. possessions.135 This provision will apply to tax years beginning after March 18, 2010 (i.e., 2011 for individuals).136

New PFIC Reporting RulesIn general, active foreign business income derived by a foreign corporation with U.S. owners is not subject to current U.S. taxation until the corporation makes a dividend distribution to those owners. However, certain rules restrict the benefit of deferral of U.S. tax on income derived through foreign corporations. One such regime applies to U.S. persons who own stock of passive foreign investment companies (PFICs).

A foreign corporation (subject to certain exceptions for banks and insurance companies) is a PFIC if either (1) 75 percent or more of its gross income for the tax year consists of passive income, or (2) the average of the percentage of its assets during the tax year that produce passive income or that are held for the pro-duction of passive income is at least 50 percent.137

Various sets of income inclusion rules apply to U.S. persons that are shareholders in a PFIC, regardless of

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their percentage ownership in the company. One set of rules applies to PFICs under which U.S. sharehold-ers pay tax on certain income or gain realized through the companies, plus an interest charge intended to eliminate the benefit of the deferral.138 A second set of rules applies to PFICs that are “qualified electing funds” (QEF), under which electing U.S. shareholders currently include in gross income their respective shares of the company’s earnings, with a separate election to defer payment of tax, subject to an interest charge, on income not currently received.139 A third set of rules applies to marketable PFIC stock, under which electing U.S. shareholders currently take into account as income (or loss) the difference between the fair market value of the stock as of the close of the tax year and their adjusted basis in such stock, subject to certain limitations and referred to as “marking-to-market.”140

Under prior law, a U.S. person that was a direct or indirect shareholder of a PFIC must file Form 8621 for each tax year in which the U.S. person recognizes gain on a direct or indirect disposition of PFIC stock, receives direct or indirect distributions from a PFIC or makes a reportable election.141

The new law amends Code Sec. 1298 by requiring each U.S. person who is a shareholder of a passive foreign investment company to file an annual in-formation return containing the information as the Secretary may prescribe. The legislative history indi-cates the Treasury will exercise regulatory authority to avoid duplicative reporting under Code Sec. 6038D with respect to foreign financial assets. See “Income Tax Return Reporting for Foreign Financial Assets”

The effective date of this provision is March 18, 2010. Some commentators have suggested that PFIC annual re-ports will be required by shareholders of PFICs for 2009 and earlier tax years PFIC returns which will be filed after March 18, 2010, the date of enactment. However, the IRS, in Notice 2010-34,142 made clear that the Treasury is developing further guidance regarding shareholder PFIC reporting under new Code Sec. 1298(f), and in the meantime only persons who were required to file Form 8621 prior to the new law must continue to file the information return as provided in the instructions to the Form (see explanation above). Shareholders of a PFIC that were otherwise not required to file Form 8621 annually prior to March 18, 2010, will not be required to file an annual report as a result of the new law for tax years beginning before March 18, 2010.

Because most taxpayers and many tax advisors do not specialize in cross-border matters, it is possible that many are either unaware or not entirely aware of

the complicated PFIC rules. It is likely that this new reporting requirement will identify “PFIC problems” long after it is too late to make a PFIC election for the first PFIC year. In certain circumstances, it may be possible to make a deemed sale or deemed dividend election (the “purging elections”), or in extremely limited circumstances a retroactive QEF election with the special consent of the IRS. The amount of deemed gain or deemed income recognized as a result of such purging elections will be still subject to the excess distribution regime, and the total tax and interest charge may be quite onerous.

In fact, in egregious cases of the long-term failure to file PFIC returns and therefore make a QEF election, the tax may exceed the entire gain on the sale of the PFIC stock and in some cases the amount realized for an effective tax rate of over 100 percent. The alterna-tives left for such a taxpayer in such a predicament are quite sparse, since any sale or disposition of the PFIC shares in either a taxable or nonrecognition transac-tion, or a conveyance via a gift would nonetheless likely trigger the tax. Presumably, if the taxpayer is elderly he or she may wait until death and have his or her estate claim a deduction for the tax. On the other hand, some commentators have suggested that this provision will likely not generate much revenue for the government because the existing PFIC requirements have been followed and because the new law does not add significant exposure for such investors.

The three-year statute of limitations period will not begin to run until “completed” PFIC returns together with the information required by the new law is pro-vided to the IRS.

Electronic Filing of Information ReturnsUnder prior law, corporations and tax-exempt or-ganizations that have assets of $10 million or more and file at least 250 returns during a calendar year, including income tax, information, excise tax and employment tax returns are required to file electroni-cally their Form 1120/1120-S income tax returns and Form 990 information returns for tax years ending on or after December 31, 2006. Private foundations and charitable trusts that file at least 250 returns during a calendar year are required to file electronically their Form 990-PF information returns for tax years ending on or after December 31, 2006, regardless of their asset size. However, taxpayers can request waivers of the electronic filing requirement if they cannot meet the requirement due to technological constraints or


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if compliance with the requirement would result in an undue financial burden.

The new law provides an exception to the general annual 250 return threshold and permits the Secretary to issue regulations to require filing on magnetic media for any return filed by a “financial institution” with respect to any taxes withheld by the financial institu-tion for which it is personally liable. (For a definition of “financial institution” see “Financial Institution.”) The Secretary is authorized to require a financial institution to electronically file returns with respect to taxes with-held under Code Sec. 1461 (e.g., FDAP withholding) or 1474(a) (FATCA withholding) by a financial institution, even if the financial institution would be required to file fewer than 250 returns during the year.

The provision also makes a conforming amended to Code Sec. 6724, permitting the IRS to assert a failure to file penalty under Code Sec. 6721 against a financial institution that fails to comply with the electronic filing requirements. This provision applies to returns required filed after March 18, 2010, without regard to extensions.

Authorize a Measurement Tool to Quantify Progress Made by Treasury to Combat International Tax Evasion

Several members of Congress at the FATCA hearing on November 5, 2009, and commentators have recom-mended that the Treasury provide Congress with periodic reports that quantify the extent of U.S. tax evasion by Americans which can be used to evaluate whether the new law is working as it was intended by the Treasury. Commentators have also pointed out that while taxpay-ers are in favor of the new laws, there is a desire to get periodic feedback confirming that their tax dollars for international compliance effort are being spent wisely.

Substitute Dividends and Dividend Equivalent Payments Received by Foreign Persons Treated As Dividends—New Code Sec. 871BackgroundPayments of U.S. source “fixed or determinable an-nual or periodical” (FDAP) income including interest, dividends and similar types of investment income made to foreign persons, such as nonresident alien in-

dividuals, foreign corporations or foreign partnerships are generally subject to a 30-percent withholding tax.143 The rate may be reduced where dividends are paid to a resident of a jurisdiction with which the United States has entered into a tax treaty.144 Divi-dends paid by a domestic corporation are generally U.S. source under Code Sec. 861(a)(2) and therefore potentially subject to U.S. withholding tax.

Source rules. The source of notional principal con-tract income is generally determined by reference to residence of the recipient of the income.145 Thus, a foreign person’s income related to a notional princi-pal contract or so-called equity swap that references stock of a domestic corporation including any amount attributable to dividends paid on the stock generally is foreign source and not subject to U.S. withholding tax. In contrast, under current law a substitute dividend payment made to the transferor of stock in a securities lending transaction or sale-repurchase is generally sourced in the same manner as actual dividends and therefore subject to U.S. withholding tax.146 Dividends paid by a domestic corporation are generally U.S. source147 and therefore potentially subject to withhold-ing tax when paid to foreign persons.

The source of notional principal contract income generally is determined by reference to the residence of the recipient of the income.148 Consequently, a foreign person’s income related to a notional prin-cipal contract that references stock of a domestic corporation, including any amount attributable to, or calculated by reference to dividends paid on the stock generally is foreign source and is therefore not subject to U.S. withholding tax.

Substitute dividend payment. In contrast, a substitute dividend payment made to the transferor of stock in a securities lending transaction or a sale-repurchase transaction is sourced in the same manner as actual dividends paid on the transferred stock.149 Accordingly, because dividends paid with respect to the stock of a U.S. company are generally U.S. source, if a foreign person lends stock of a U.S. company to another person (or sells the stock to the other person and later repurchases the stock in a transaction treated as a loan for U.S. federal income tax purposes) and receives sub-stitute dividend payments form that other person, the substitute dividend payments from that other person, the substitute dividend payments are U.S. source and are generally subject to U.S. withholding tax.150

Notice 97-66. In 1997, the Treasury issued final regulations governing withholding on securities lending transactions. In response to concerns by the financial

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services industry that a “cascading withholding tax” could cause U.S. withholding tax to be due on pay-ments of interest or dividends made on securities that were lent multiple times, Notice 97-66151 was issued by the IRS which addressed the tax treatment of substitute dividend payments made between foreign persons and generally sought to impose limitations on the imposi-tion of withholding tax in such cases. More specifically, the Notice provided that, “the amount of U.S. with-holding tax to be imposed under Treasury Regulation Sec. 1.871-7(b)(2) and 1.881-2(b)(2) with respect to a foreign-to-foreign payment will be the amount of the underlying dividend multiplied by a rate equal to the excess of the rate of U.S. withholding tax that would be applicable to U.S. source dividends paid by a U.S. per-son directly to the recipient of the substitute payment over the rate of U.S. withholding tax that would be ap-plicable to U.S. source dividends paid by a U.S. person directly to the payor of the substitute payment.”

Congressional Hearings—September 2008. On September 11, 2008, the Senate Permanent Subcom-mittee on Investigations had a hearing to investigate transactions structured by financial institutions that was aimed, in part, at enabling non-U.S. clients to avoid U.S. withholding taxes by using equity swaps or stock lending transactions. The Hearing culminated in a report entitled, Dividend Tax Abuse: How Offshore Entities Dodge Taxes on U.S. Stock Dividends, which discussed so-called, “abusive equity swaps” and raised concerns that Notice 97-66 was being used by taxpay-ers to justify tax avoidance transactions including where a foreign person would lend U.S. stock to a foreign financial institution who would then sell the stock to a related U.S. person and at the same time enter into a total return equity swap with this U.S. person. At the hearing, IRS Commissioner Douglas Shulman was strongly requested to remedy the problem.

In the Obama Administration’s fiscal year 2010 bud-get, the Treasury has announced that to address the avoidance of U.S. withholding tax through the use of securities lending transactions, it plans to revoke Notice 97-66 and issue guidance that eliminates the benefits of those transactions but minimizes over-withholding.152

Stop Tax Haven Abuse Act. On March 2, 2009, Senator Carl Levin introduced legislation entitled the “Stop Tax Haven Abuse Act” (S. 506, H.R. 1265) (the “Levin Bill” or “Bill”). As part of this legislation proposal, Section 108 entitled, “Closing the Offshore Dividend Loophole,” was included in the Bill to en-sure non-U.S. persons pay taxes on U.S. dividends whether cast as equity swaps, stock loans or other

arrangements. Bill Section 108(d) provided that the provision would be effective and apply to payments made on or after the date that is 90 days after the date of enactment.

The Bill included the following dividend equivalent provisions:

Withholding tax on dividend equivalents and sub-stitute dividend payments. Section 108(a) of the Bill would add new Section 871(l) to the Code and impose a 30-percent withholding tax on dividend equivalents and substitute dividend payments which would be treated as a dividend for purposes of Code Secs. 871 and 881, and therefore subject to U.S. withholding tax under Code Secs.1441 and 1442. Under new Code Sec. 871(l)(1)(A) the term “dividend” shall include “dividend equivalents” and “substitute dividends,” and new Code Sec. 871(l)(1)(B) and (C) would source a dividend equivalent with stock of one or more domestic corporations as sourced within the United States, and a substitute dividend payment would be sourced in the same manner as a dividend distribution with respect to the transferred security to which the substitute dividend relates. Although not specifically indicated, presumably the Levin Bill would require withholding on gross payments rather than net.

Definition of “dividend equivalent.” The Levin Bill defined a “dividend equivalent” as any payment that is made pursuant to a notional principal contract and is contingent upon, or referenced to, the payment of a dividend on stock or the payment of a dividend on property that is substantially similar or related to stock (determined in a manner similar to the manner under Code Sec. 246(c)(4)(C)). For this purpose, the term “notional principal contract” means a financial instrument that provides for the payment by one party to another at specified intervals calculated by refer-ence to a specified index upon a notional principal amount in exchange for a specified consideration or a promise to pay similar amounts.

The Levin Bill would define a “substitute dividend” as a payment made to the transferor of a security in a securities lending transaction or a sale-repurchase transaction, of an amount equivalent to a dividend distribution which the owner of the transferred se-curity is entitled to receive during the term of the transaction. A “securities lending transaction” means a transfer of one or more securities that is described in Code Sec. 1058(a) or a substantially similar trans-action and a sale-repurchase transaction means an agreement under which a person transfers a security in exchange for cash and simultaneously agrees to


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receive substantially identical securities from the transferee in the future in exchange for cash.

Exceptions to dividend withholding. Unlike the Green Book Proposal and FATCA, the Levin Bill does not contain any exceptions for dividend equivalency with-holding, and unlike the Extenders Act does not expressly authorize the Treasury to write such exceptions.

Avoidance of over-withholding. Under proposed new Code Sec. 871(l)(5) the Levin Bill provides that in the case of any dividend equivalent or substitute dividend that is subject to withholding under this Sec-tion or Code Sec. 881, the Secretary may by regulation reduce such withholding, but only to the extent that the taxpayer can establish that the dividend for which the payment to be withheld upon is a dividend equivalent or a substitute dividend that was previously withheld upon under this Section or under Code Sec. 881.

Regulatory directive for netting of payments and other transactions. Under Section 108(b) of the Levin Bill, the Treasury is authorized to issue regulations to address the imposition of withholding in cases where dividend equivalent payments under notional princi-pal contracts are netted with other payments under the same instrument, in cases where fees and other payments are netted to disguise the characterization of a payment as a substitute dividend, and in cases where option or forward contracts or similar ar-rangements achieve the same or substantially similar economic results as the notional principal contracts covered under new Code Sec. 871(l).

Qualified intermediaries. Under Section 108(c) of the Bill, the Treasury was directed to ensure that any qualified intermediary withholding agreement that the United States enters into or renews after the date of enactment with a foreign financial institution or foreign branch of a U.S. financial institution con-forms with the amendments made by this section to ensure appropriate withholding related to dividend equivalents and substitute dividends.

Green Book proposal. On May 11, 2009, the Obama Administration released the General Explana-tion of the Administration’s Fiscal Year 2010 Revenue Proposals (the “Green Book Proposal”). While the Administration did not release statutory language as part of this proposal, the Green Book provided sig-nificant detail about the Administration’s Fiscal Year 2010 budget proposal. As part of the Green Book Proposal, the Administration had a provision entitled, “Prevent the Avoidance of Dividend Withholding Taxes,” which would be effective for payments made after December 31, 2010.

Reasons for change. The Green Book proposal points out that foreign portfolio investors seeking to benefit from the appreciation in value and dividends paid with respect to stock of a domestic corporation are not limited to holding stock in the corporation. Instead, such an investor can enter into an equity swap. The U.S. tax consequences of these two alterna-tive investments differ significantly. By entering into equity swaps, foreign portfolio investors receive the economic benefit of dividends paid and appreciation in value with respect to U.S. stock without being subject to gross-basis withholding tax.

Securities lending. In order to address the avoidance of U.S. withholding tax through the use of securities lending transactions, the proposal contemplates that the Treasury would revoke Notice 97-66 and issue guidance that would address over-withholding, that is, address the concern involving a “cascading effect” of a dividend withholding tax while still closing the door to abusive transactions.

Equity swaps—General rule. Income earned by foreign persons with respect to equity swaps that reference U.S. equities would be treated as U.S. source to the extent that the income is attributable to, or calculated by reference to dividends paid by a domestic corporation and subject to withhold-ing. The Green Book Proposal does not indicate whether withholding would be imposed on gross or net payments.

Exception to equity swap withholding. An excep-tion to the general rule imposing U.S. withholding tax on equity swaps would apply to swaps with all of the following characteristics under the Green Book Proposal:

The terms of the equity swap do not require the foreign person to post more than 20 percent of the value of the underlying stock as collateral.The terms of the equity swap do not include any provision addressing the hedge position of the counterparty to the transaction.The underlying stock is publicly traded.The notional amount of the swap represents less than both five percent of the total publicly traded float of that class of stock over which the equity swap is executed, and less than 20 percent of the 30-day average daily trading volume.The foreign person does not sell the stock to the counterparty at the inception of the contract (i.e., there is no crossing-in) or buy the stock from the counterparty at the termination of the contract (i.e., there is no crossing-out).

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The prices of the equity that are used to measure the parties entitlements obligations are based on an “objectively observable price.”The swap has a term of at least 90 days.

The Treasury would be given regulatory authority to provide exceptions to implement the purpose of the rule.

FATCA—Section 501. On October 27, 2009, Sena-tors Baucus and Kerry, together with Representatives Rangel and Neal introduced the Foreign Account Tax Compliance Act (H.R. 3933, S.1934), (“FATCA” or the “Act”). As part of this legislative proposal, Sec-tion 501 entitled, “Dividend Equivalent Payments Received by Foreign Persons Treated as Dividends,” was included in the Act to prevent taxpayers from avoiding U.S. withholding tax by using swaps and other arrangements marketed as a means of avoiding U.S. withholding tax. Section 501(b) of the FATCA provided “The amendments made by this section shall apply to payments made on or after the date that is 90 days after the date of the enactment of this Act.”

FATCA included the following dividend equivalent provisions:

Withholding tax on dividend equivalent payments. Section 501(a) would add new Code Sec. 871(l) to the Code and would treat a “dividend equivalent” as a dividend from U.S. sources for purposes of Code Secs. 871 and 881 and thus subject to the U.S. with-holding tax under Code Secs. 1441 and 1442.

Meaning of “dividend equivalent.” A dividend equivalent under new Code Sec. 871(l)(2)(A) is any payment made under a notional principal contract (i.e., a swap) that is directly or indirectly contingent upon or determined by reference to a dividend from U.S. sources within the United States and grants the Treasury the authority to identify as dividend equivalents any other transactions or payments that are substantially similar to dividend equivalents.153 The Joint Committee on Taxation Explanation also mentions payments under forward contracts or other financial contracts that reference stock of U.S. cor-porations may be dividend equivalents.154

SIFMA Comments on FATCA “dividend equiva-lent.” The Securities Industry and Financial Markets Association comments to the House Ways and Means Committee and the Senate Finance Committee on November 19, 2009 on FATCA had the following discussion related to the term155:

What is a “dividend equivalent payment,” and what is its amount in any given case? Under the

provision, if a foreign investor promises to pay a U.S. counterparty an amount equal to LIBOR mi-nus a dividend, that will be treated as a dividend equivalent payment going in the opposite direc-tion (i.e., from the U.S. counterparty to the foreign investor), even though the foreign investor doesn’t receive anything. Does it follow that if a contract provides for a payment equal to twice LIBOR mi-nus twice dividends, the foreign investor is deemed to receive two dividend equivalent payments? In any case, presumably this novel treatment should only be applied where the relevant contract also provides for payments based on the value of relevant equities, but this is not clear from the language of the provision. Even if we assume that to be necessary, however, it is not clear how we should treat contracts that have embedded caps, floors or collars, such as the sort that are currently found in prepaid forward contracts.

Suppose, on the other hand, that a contract pro-vides a foreign person with the right to benefit from appreciation in the value of U.S. equities but does not provide for any change in payments based on changes in the amount of dividends paid on those equities. This is often the case where the relevant U.S. corporation rarely changes the amount of its dividends, since the anticipated amount of dividends to be paid over the life of the contract can in that case simply be reflected in the opening or closing price of the contract. It is not clear from the language of the Provision whether such a contract should be deemed to provide for embedded dividend equivalent pay-ments. It is likewise not clear whether and how much it would matter if the word “dividends” was referenced somewhere in the contract.

It is also not clear whether the provision would apply if payments changed when dividends unex-pectedly increased, but not when they decreased; or if they changed when dividends decreased, but not when they increased; or if they changed by only a small amount in relation to the amount of the change in dividends. Many equity related contracts (especially forward contracts) provide for a change in payments if and when dividends change by an “extraordinary amount.” It is not clear whether (and when) such a provision would be viewed as giving rise to dividend equivalent payments, and if so, whether such payments


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would be deemed to accrue in the absence of any such extraordinary event.

SIFMA Comments on the timing of the accrual of dividend equivalent payments. The SIFMA Comments on FATCA also addressed issues related to the timing of the accrual of dividend equivalent payments by providing156: “What would the timing of the accrual of these dividend equivalent payments be? It is not clear to us, for example, whether a payment at maturity of a contract that was determined by reference to a “look back” at the difference between interest rates and dividend rates over the life of the contract would give rise to deemed dividend equivalent payments only at maturity of the contract or whether dividend equivalent payments would instead be deemed to ac-crue periodically over the life of the contract.

SIFMA Comments suggest difficult issues for system implementation and enforcement. The SIFMA Comments suggest that the new provision would create difficult issues of implementation and enforcement for this novel system and raised the following issues157:

The provision would constitute a novel means of imposing tax on foreigners and would raise difficult issues that were matters of first impression for systems implementation and enforcement. More specifically, the proposal would impose tax not on payments received by foreigners, but rather on hypothetical de-rivative rights.158 For example, suppose a foreign person enters into an equity swap and later closes out the swap with no payments made by either party. Under the proposal, the foreign person might be subject to substantial U.S. withholding tax, because the net zero payment on termination of the swap might notionally reflect a deemed payment from the foreign person to the U.S. person reflecting either notional interest or a decline in the value of the underlying equity offset by a deemed payment from the U.S. person to the foreign person reflecting deemed dividend equivalent payments. By contrast, current law does not even im-pose tax on original issue discount accrued by foreign persons unless and until they receive a payment.159

A complex and well-thought-out regime currently exists to allow financial institutions to withhold and remit to the IRS a portion of any amounts that they actually pay to foreign persons (including dividend or interest payments, and in some cases gross sales proceeds). This regime itself took a substantial amount of time and thought to develop. By way of example, the modification of withholding systems that was

implemented when the Code Sec. 1441 withholding tax rules went into effect on January 1, 2001 took three years to implement.160 But no regulatory regime, no standard form legal agreements, no enforcement methodologies, no collateralization programs and no computer systems currently exist to allow financial institutions to impose and collect a tax in the absence of any such payments.

How, moreover, will computer systems analyze the terms of each of a large volume of equity derivative contracts to determine not just the amount of the payments they provide for, but:

whether they contain embedded “dividend equivalent payments,” what is the amount of these dividend equivalent payments, whether the contracts themselves constitute “no-tional principal contracts” within the meaning of relevant regulations, and whether the contracts themselves fall within the terms of the relevant safe harbor?

The novel tasks that need to be performed to allow financial institutions to navigate these unchartered waters will be in addition to those that need to be performed in connection with any major change to withholding tax procedures.161

Meaning of “notional principal contract.” The Act does not define the term “notional principal contract” proposed by Code Sec. 871(l), but the Staff of the Joint Committee on Taxation Explanation for FATCA at footnote #213 references Reg. §1.863-7(b)(1), which provides, “A notional principal contract is a financial instrument that provides for the payment of amounts by one party to another a specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts.” The SIFMA Comments on FATCA162 raised the follow-ing issues relating to the definitional clarity for the term notional principal contract:

What is a “notional principal contract for this purpose? Reg. §1.863-7(a)(1) (like Reg. §1.446-3(c)(1)) currently defines a notional principal contract as a financial instrument that provides for the payment of “amounts” by one party to another at specified “intervals.” Does this mean that financial institutions can safely enter into bullet equity swaps (which provide for payments only at maturity) without any risk of withholding tax penalties? The answer could conceivably be no, because the current-law definition serves primarily

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as a “gateway” to a desirable tax treatment—i.e., residence-based sourcing—and is therefore arguably limited in nature. But if there is a risk of imposition of withholding tax on bullet swaps, then what about dividend adjusted equity forward contracts, since they are economically equivalent to bullet swaps? What about dividend-adjusted prepaid forward contracts? What about economically equivalent exchange traded notes? And what about derivative positions in pub-lished stock indexes, such as the S&P 500? There are very large volumes of these sorts of contracts currently outstanding on capital markets.

Exceptions to dividend equivalency withholding. Proposed Code Sec. 871(l)(2)(B) grants the Treasury the authority to exclude any payment that it deter-mines does not have the potential for tax avoidance and lists the following six nonexclusive factors that the Treasury may take into account163:

The term including provisions for early termina-tions and the existence of offsetting financial contracts The amount of each party’s investment and the amounts of any collateral posted Whether the price of the equity used to measure the parties entitlements or obligations is based on an objectively observable price or the parties actual execution prices Whether either party sells directly or indirectly to the other party the stock or security giving rise to the dividends from sources within the United States (“cross-in/cross-out”), Whether there are terms that address the hedge position of either party or other conditions which would compel either party to hold or acquire the stock or security giving rise to dividends from sources within the United States Such other factors as Treasury deems appropriate

Neither the Act nor the Joint Committee on Taxa-tion specifies the relevance of the factors. The list indicates that the exceptions should have a fairly broad application.

The Treasury may determine based on these and oth-er factors that it may take into account that a contract with a short term that includes a dividend payment date or a contract under which a party hedges its obligations to make dividend-based payments by holding the underlying stock is more likely to have the potential for avoidance of dividend withholding tax than a contract with a longer term or contract under which the party does not hedge its obligations.164

FATCA proposed effective date is unrealistic. Un-der FATCA, all dividend equivalent payments would be subject to a 30-percent withholding tax unless, within 90 days of enactment, the Treasury issues regulations that except payments on certain swaps.

SIFMA in its FATCA Comments has serious concerns about the ability of the industry to implement the new structure in a timely fashion as well as issues related to forced terminations of a broad range of equity derivative contracts that have already been entered into and economic concerns about hedging and other structures which have already been implemented prior to the date of enactment. SIFMA Comments related to these issues are as follows165:

In our view, the provision’s proposed effective date is not realistic. As currently drafted, the Provision would take effect for all payments deemed made 90 days or more after the date of enactment (a) regardless of whether or when the Treasury Department actually promulgated regulations, and (b) regardless of whether finan-cial institutions had the means of implementing such withholding. There are a number of serious problems with this approach.

First, drafting the necessary regulations is going to take time, and we do not think it is realistic to suppose that the Treasury Department could accomplish the task in 90 days, especially given the other projects that the Bill will put on its plate. At the very least, the Treasury Department will need to develop the “safe harbor” that has become so central to the concept of the Provi-sion. But numerous other questions will have to be resolved, some of which have already surfaced, but others of which may only come to the fore as the Treasury Department and the legal community begin to focus on the question of how to implement the new regime.

By way of example, set out below are a few of the questions that industry tax directors have already been asking themselves in their efforts to prepare for the potential implementation of the Provision. These questions arise directly from the terms of contracts that are currently being entered into in substantial volume, and it is clear that investors, traders, bankers and back office staff will be actively asking them as soon as the provision is enacted. We think the Treasury Department will want to provide


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answers in time to avoid triggering a large-scale, and unintended, termination of equity-related financial contracts (and an associated disintermediation by financial institutions in U.S. equity-related financial relationships). We note, in this regard, that financial institutions serve primarily as intermediaries in fi-nancial markets and earn a relatively thin “spread” in respect of this role. This is a legitimate and im-portant role in the U.S. economy, but there is little room in it for the risk of imposition of unanticipated taxes or penalties on the gross amount of deemed underlying cash flows; such taxes and penalties would quickly dwarf any associated profits. We also think the Treasury Department will want to answer these questions to avoid forcing the trading desks of financial institutions to compete with each other partly on the basis of their interpretation of ambiguous legal authority.

Third, the relevant persons (including Treasury officials, financial institutions, their inside and outside counsel, and their compliance departments) cannot begin working on the nec-essary regulatory regimes, standard form legal agreements, enforcement methodologies, col-lateralization programs and computer systems until Treasury completes its work of fleshing out the circumstances under which it deems it appro-priate to impose a withholding tax on notionally embedded dividend equivalent payments. As noted above, this is going to take some time.

Fourth, if the proposal were to take effect before the Treasury Department had issued detailed regulations (or after Treasury had issued such regu-lations but before the relevant persons mentioned above had an opportunity to develop the contracts, systems and programs mentioned above), then fi-nancial institutions and their counterparties would be forced to immediately terminate a broad range of equity derivative contracts with no clear notion of what might replace them.

For example, few notional principal contracts, forward contracts or other equity derivative contracts currently provide for the payment by a foreign counterparty of U.S. withholding taxes. To the contrary, such contracts generally provide that payments under the contract will be made free and clear of any such taxes and they require the U.S. counterparty to gross the foreign counter-

party up for the amount of any U.S. withholding tax imposed on the counterparty. Neither are there any legal systems, computer systems or administrative systems in place that might allow a financial institution to distinguish contracts that might safely be left in place (because they would probably not be subject to withholding) from contracts that had to be terminated immediately (because they would probably be subject to with-holding). Given that potential penalties would be imposed on the gross amount of deemed em-bedded payments, rather than on relatively slim net profits, financial institutions would therefore likely be forced to terminate most of their equity derivative contacts and there could be substantial disruption in equity markets.

Similarly, many financial institutions have struc-tured their internal affairs in manners that presume the absence of any U.S. withholding tax on cross-border equity derivative contracts. Suppose, for example, that a U.K. investor enters into an equity swap over a U.S. stock with the U.K. affiliate of a financial institution. The U.K. affiliate will normally hedge by entering into a “mirror” equity derivative transaction (e.g., an equity swap) with a U.S. affili-ate, which U.S. affiliate will then hedge its resulting short position by acquiring a long position (e.g., the U.S. stock itself, or a long swap position in the U.S. stock) in the more liquid U.S. market. Yet this approach would suddenly result in the imposition of two U.S. withholding taxes—one on payments from the U.S. affiliate to the U.K. affiliate, and one on payments from the U.K. affiliate to the U.K. in-vestor. Such internal structures cannot be easily, or instantly, changed. Most major financial institutions operate both inside and outside the United States, and a complex web of market forces, systems ca-pabilities, U.S. regulatory rules, foreign regulatory rules, accounting issues, compensation-related is-sues and other factors govern the internal structures through which they offer, hedge and maintain their financial positions. Moreover, there is absolutely no room in the “margins” of these transactions for the imposition of a 30 percent gross U.S. withholding tax on internal cash flows.

Conclusion. For the reasons set out above, we recommend that the imposition of withholding tax on dividend equivalent payments be delayed until a date that is at least 18 months after the

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date on which the Treasury Department promul-gates currently effective guidance that (i) sets out the requirements for availability of a safe harbor from the implementation of withholding on divi-dend equivalent payments (ii) defines dividend equivalent payments for this purpose (iii) defines notional principal contracts for this purpose, and (iv) defines any other equity derivative contracts to which the provision is intended to apply.

ABA Tax Section Comments on FATCA. The ABA Tax Section Comments made the following recom-mendations relating to new Code Sec. 871(l):

1. Effective Date Should Allow Treasury Time to Implement Exceptions to Dividend Equivalents and to Allow Institutions Close-out of Existing Swaps. “Guidance implementing the authorized exceptions should be promulgated sufficiently in advance of the provision’s effectiveness to allow institutions to assess their outstanding contracts and come into compliance. This is not necessarily provided under the current effective date, in that it is not tied to the promulgation of guidance and may be an inadequate period even if the rules were known on enactment.

For the most part, outstanding equity swaps that would be adversely affected under Section 501 would be terminated if the Bill is enacted, either pursuant to the terms of the swap (i.e., as a result of a Change of Tax Law or Change of Law provi-sions under standard ISDA documentation) or my mutual agreement between the counterpar-ties, to avoid a gross-up for amounts withheld. A mutual agreement may take a longer period than provided by the effective date for Section 501 of the Bill, particularly for a party that has entered into numerous equity swaps.

2. Consider Grandfathering of Existing Contracts. We recommend that existing contracts be except-ed from the application of section 871(l), at least for some period, so that taxpayers are not unfairly penalized for their outstanding equity swaps and derivatives that were entered into based upon cur-rent law and may close out existing swaps in an orderly fashion. We recommend that this apply to such contracts entered into before, or pursu-ant to a binding agreement in existence before October 28, 2009.

3. Exceptions from Dividend Equivalents. A pay-ment made under a notional principal contract that is directly or indirectly contingent upon or determined by reference to the payment of a U.S. source dividend would be treated as a dividend equivalent subject to U.S. withholding tax unless identified as non-abusive, commercial transac-tion by Treasury. Conversely, other transactions are so treated only if first identified by Treasury, either under the five factors identified in FATCA or “any other factors” it deems appropriate.

We agree that deferring the issue of demarcating between abusive and non-abusive transactions to Treasury are the appropriate approach for such a complex and fact-specific subject matter and that the relevant factors are generally set forth in sufficient breath to permit rles to be developed.

We understand why the statute would be drafted with a residual rule treating dividend equivalents in respect of notional principal contracts as U.S. source withholdable payments. Our primary concern, as noted above, is that sufficient lead time be permitted in the statute initially and by delegation of authority to Treasury, to allow for the creation of appropriate exceptions in a timely way. The normal Treasury regulation process would put taxpayers on fair notice and allow for consulta-tion with taxpayers and industry groups with the appropriate expertise and knowledge about the market place. Thus, we recommend that the re-sidual rule for sourcing not become effective until appropriate exceptions have been identified.

4. Avoid Double Withholding on Equity Swaps. There is an issue of possible double withholding because of the way equity swap business is done at a number of taxpayers. Firms often centralize their swap trading activities in one legal entity to achieve netting benefits for credit and balance sheet purposes. However, the risk for the posi-tions may be managed in a different legal entity so there is a mirror internal swap for each client swap. The mirror swap creates the potential for double withholding. We recommend that consid-eration should be given to an exemption for the second withholding tax when the taxpayer is able to demonstrate to the IRS that an internal mirror situation exists and withholding tax actually was imposed at gross on the first client swap.


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Further, we believe the legislation could apply to swaps between two foreign parties. In such a case, if the first foreign party has been subject to withholding on a dividend or dividend equivalent to which the swap relates, the payment to the second foreign party should not again be subject to withholding (other than to the extent the ap-plicable withholding rates on such payment may be higher than the rate applicable to the initial payment). A similar problem was addressed by the IRS in connection with the securities lend-ing166 and a similar approach should be adapted to the proposed legislation.

Avoidance of withholding—Comparison of FATCA to Green Book proposal. David Miller167 from Cad-walader Wickersham & Taft LLP recently compared the Green Book Proposal to the FATCA proposal in order to avoid U.S. withholding tax based on the following discussion:

1. Maximum 20 percent Collateral. Under the Green Book Proposal, the foreign person cannot post collateral with a value that exceeds 20 percent, while FATCA would consider the amount of each party’s investment and the amount of collateral posted. While 100 percent collateral looks like an investment in stock, inadequate collateral ex-poses a U.S. counterparty to credit risk of a foreign counterparty. What is the proper percentage? 40 percent?, 50 percent? When should it be tested? If testing is continuous, what happens if the collateral exceeds 20 percent of the value for one day only? Does the 100 percent of all future dividend pay-ments then become subject to withholding? What if the underlying stock becomes more volatile or the counterparty’s credit profile changes?

2. Counterparty’s Hedging Strategy. To avoid withholding, the Green Book Proposal would prohibit an equity swap from addressing the hedging strategy of the counterparty to the swap. FATCA would consider whether there are terms that address the hedge position of either party or other conditions which would compel either party to hold or acquire the security giving rise to U.S. source dividends. It’s not clear what this means. Presumably, the foreigner cannot vote the shares held by its counterparty. The Green Book Proposal appears to prohibit execution pricing (i.e., the price at which the counterparty

purchases securities used to hedge its position).

3. Fungibility/Liquidity of the Underlying Stock. To avoid withholding the Green Book Proposal would require the swap to refer to only publicly traded stock and must only represent less than five percent of the total public float of that class of stock subject to the swap, and more than 20 percent of the 30-day average daily trading volume of the stock Under this proposal when would this test be made—at the inception or on an ongoing basis? What if an issuer buys back its outstanding stock? What if the underlying stock becomes less actively traded? FATCA would consider whether there are conditions which would compel either party to hold or acquire the stock and would limit cross-border equity swaps to only the most liquid stocks.

4. No Cross-In/No Cross-Out. Under the Green Book Proposal the foreign person cannot sell the stock to the counterparty at the beginning of the contract or buying it from the counterparty at the termination of the contract. FATCA would consider whether either party sells directly or indirectly to the other party the stock. Presumably, cross-ins and cross-outs suggest an agency relationship. Under either proposal, can the foreigner sell the stock into the market at the market-on-open or market-on-close price and enter into a swap at the same price? If the counterparty also purchases its hedge at the same price, would that be viewed as a constructive or indirect cross-in or cross-out?

5. Objectively Observable Price. Under the Green Book Proposal, to avoid withholding the prices of the equity that are used to determine what the par-ties will receive and pay under swap must be based on objectively determinable prices. FATCA would require that the price of the equity used to measure the parties’ entitlements or obligations is based on an objectively observable price or the parties’ actual execution prices. Do “market-on-open” (“MOO”), “market-on-close” (“MOC”) volume-weighted av-erage price (“VWAP”), and time-weighted average price (“TWAP”) satisfy this standard? If market-on-open and market-on-close satisfy the standard, does it matter if the counterparty buys its hedge at the same price? What about a one minute TWAP?

6. Term of the Swap. To avoid withholding under the Green Book Proposal the swap must have a

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term of at least 90 days. FATCA considers the term including provisions for early terminations and the existence of offsetting financial contracts. It is very likely that a one-day swap over the dividend record date is abusive, regardless of whether the swap is actually terminated or offset by another swap. Will 90 days be a proper term? How about 15 days (Code Sec. 901(k); 30 days (Code Sec. 1091); 46 days (Code Sec. 246)? If the foreigner enters into an offsetting swap with another counter party within 90 days, how would the first counterparty know to withhold? What if the termination of a swap with 90 days has no relationship to the payment of dividends (e.g., statistical arbitrage trade)? What if the counter-party goes bankrupt within 90 days? What if the swap is entered into on day 1, dividend paid on day 10, and swap terminated on day 45? Does the counterparty have an obligation to withhold after the fact?

7. Dividend Equivalency Withholding Based on Gross Amount. New Code Sec. 871(l)(2)(C) pro-vides the dividend equivalent amount subject to U.S. withholding tax would be based on the gross amount used rather than net amounts transferred to, or from the taxpayer under a notional principal contract. A party to a total return swap may be obligated to withhold and pay tax to Treasury on a gross dividend-based amount even though the party is not required to make an actual payment to its foreign counterparty.

For example, under a typical “total return swap” referencing stock of a domestic corporation (an example of an notional principal contract to which FATCA applies), a foreign investor enters into an agreement with a counterparty under which amounts due to each party are based on the returns generated by a notional investment in a specified dollar amount of the domestic corpo-ration’s stock. The investor agrees for a specified period to pay to the counterparty (1) an amount calculated by reference to a market interest rate (such as the London Interbank Offered Rate (“LI-BOR”) on the notional amount of the domestic corporation’s stock and (2) any depreciation in the value of the stock. In return, the counterparty agrees for the specified period to pay the investor (1) any dividends paid on the stock and (2) any appreciation in the value of the stock.

Amounts owed by each party under this swap are a net amount determined in part by other amounts (for example, the interest amount and the amount of any appreciation or depreciation in value of the referenced stock). Accordingly, a counter party to a total return swap may be obligated to withhold, and remit tax on the gross amount of a dividend equivalent even though, as a result of netting of payments due under the swap, the counterparty is not required to make an actual payment to the foreign investor.

8. Control over Payment. Each person that is a party to a contract or other arrangement that provides for the payment of a dividend equivalent will be treated as having control over the payment for purposes of Chapter 3 of the Code (with-holding of tax on nonresident aliens and foreign corporations) and Chapter 4 (taxes to enforce reporting on certain foreign persons).168

Green Book 2011 proposal. The Green Book 2011 Proposal also has a provision that addresses dividend equivalent payments,169 which appears to be the same as the proposals in the Extenders Act enacted into law. See “HIRE Act—Section 541.”

HIRE Act—Section 541. The HIRE Act incorporated and made changes to the dividend equivalency provi-sions under Section 501 of FATCA. The new provision became Section 541 and is now entitled, “Substitute Dividends and Dividend Equivalent Payments Re-ceived by Foreign Persons Treated as Dividends.”

HIRE Act—Effective date of dividend equivalency provisions. Section 541(b) of the HIRE Act states: “The amendments made by this section shall apply to pay-ments made on or after the date that is 180 days after the date of enactment of this Act.”170 Thus, a 30-percent dividend withholding tax will apply to payments for equity swaps or other arrangements if the notional principal contract meets the four conditions specified under new Code Sec. 871(l)(3)(A) beginning Septem-ber 14, 2010 (e.g., for any payments made on or after 180 days after the date of enactment), or is otherwise identified by the Treasury as such a contract.171

Beginning on this same date a 30-percent withhold-ing tax will be imposed on any substitute dividend payment made pursuant to a securities lending or sale-repurchase transaction that is directly or indi-rectly contingent upon or determined by reference to the payment of a U.S. source dividend to a foreign party. In addition, it can be expected that withhold-


September 2010

able payments under new Code Sec.1471will include certain payments arising in connection with securities lending and notional principal contracts including (1) rebate fees (interest paid by U.S. lenders), (2) U.S. source borrow fees paid by U.S. borrowers, (3) substitute U.S. interest/dividend payments, and (4) outbound repo spreads (interest).172

The new law,173 however, delayed application of U.S. withholding tax for payments made within two years of the date of enactment for notional principal contracts not subject to withholding under new Code Sec. 871(l)(3)(A). More specifically, under new Code Sec. 871(l)(3)(B), the new term “specified notional principal contract” will also include payments made on any notional principal made after the date which is after March 18, 2012 (e.g., two years after the date of the enactment of Section 541), unless the Treasury determines that such contract is of a type which does not have the potential for tax avoidance.174 See “De-layed Application of Withholding for Certain Notional Principal Contracts Not Otherwise Subject to With-holding Tax Under New Code Sec. 871(l)(3)(A).”

Withholding tax on dividend equivalent payments. Section 541(a) of the HIRE Act would add new sec-tion 871(l) to the Code and would treat a “dividend equivalent” as a dividend from U.S. sources for purposes of Code Sec. 881 (and presumably Code Sec. 871), and as a consequence subject to U.S. withholding tax under Code Secs.1441 and 1442.175 The new law specifically references the application of Chapter 3 of the Internal Revenue Code (dealing with withholding under Code Secs. 1441–1446) and new Chapter 4 (dealing with withholding under new Code Secs. 1471–1474), as well as makes reference to Code Sec. 4948(a) (dealing with withholding of tax on gross investment income of foreign private founda-tions subject to the Code Sec. 4948(a) excise tax).

Under new Code Sec. 871(l)(2), the term “dividend equivalent” will mean:

any “substitute dividend” made pursuant to a securities lending or sale-repurchase transaction that (directly or indirectly) is contingent upon, or determined by reference to, the payment of a U.S. source dividend;any payment made pursuant to a “specified notional principal contract” that (directly or indirectly) is contingent upon, or determined by reference to, the payment of a U.S. source dividend; and any other payment determined by the Secretary to be substantially similar to a “substitute dividend”

or a “specified notional principal contract” that is contingent on, or determined by reference to a U.S. source dividend.

For this purpose, a dividend equivalent includes any substitute dividend as defined in Reg. §1.861-3(a)(6).176 While both FATCA and the HIRE Act proposals have a catch-all for the Treasury to identify transac-tions substantially similar to payments arising under a notional principle contract, the HIRE Act specifically adds “substitute dividends” to the definition, and then defines a new term, “specified notional principal contract” as a dividend equivalent.177 In addition, the Treasury may conclude that payments under certain forward contracts or financial contracts are dividend equivalents.178

Specified notional principal payment. Under new Code Sec. 871(l)(3)(A) a “specified notional principal contract” means any notional principal contract if:

in connection with entering into such contract, any long party transfers the underlying security to any short party to the contract (i.e., “crossing-in”),179 in connection with the termination of such con-tract, any short party transfers the underlying security to any long party to the contract (i.e., “crossing out”),180 the underlying security is not readily tradable on an established securities market,181

in connection with entering into such contract, the underlying security is posted as collateral by any short party to the contract,182or such contract is identified by the Secretary as a specified notional principal contract. 183

Based upon this definition, dividend withholding will apply to any equity swaps or other arrangements that satisfies each of the identified first four conditions above, or is otherwise identified by the Treasury as such a contract for any payments made beginning September 14, 2010.

Definition of “long party,” “short party” and “underlying security.” For purposes of these char-acteristics the term “long party” means with respect to any underlying security of any notional principal contract, any party to the contract which is entitled to receive any payment pursuant to such contract which is contingent upon, or determined by reference to, the payment of a dividend from sources within the United States with respect to the underlying security.184 The term “short party” means with respect to any underly-ing security of any notional principal contract, any party to the contract which is not a long party with respect to such underlying security.185

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The term “underlying security” means with respect to any notional principal contract, the security with respect to which the dividend referred to in new Code Sec. 871(l)(2)(B).186 For this purpose, any in-dex or fixed basket of securities will be treated as a single security.187

Agency relationship and treatment of foreign party as beneficial owner—No inference intended. The legislative history provides that no inference is intended as to whether the definition of specified notional principal contract, or any determination under the new law that a transaction does not have the potential for the avoidance of taxes on U.S. source dividends, is relevant in determining whether an agency relationship exists under general tax prin-ciples or whether a foreign party to a contract should be treated as having beneficial tax ownership of the stock giving rise to U.S. source dividends.188

Delayed application of withholding for certain notional principal contracts not otherwise subject to withholding tax under new Code Sec. 871(l)(3)(A). Under new Code Sec. 871(l)(3)(B) the new term “specified notional principal contract” will also include payments on any notional principal contract made after the date which March 18, 2012 (e.g., two years after the date of the enactment of Section 541), unless the Treasury determines that such contract is of a type which does not have the potential for tax avoidance. Thus, the HIRE Act will delay the application of U.S. withholding tax for certain payments made within two years of the date of enactment, in the case of notional principal contracts which does not otherwise satisfy the four conditions enumerated under new Code Sec. 871(l)(3)(A) or is otherwise determined by the Treasury to be a specified notional principal contract.

Exceptions to dividend equivalency withholding. The FATCA proposal authorized the Treasury to make an exception from withholding for any payment under a contract or other arrangement it identifies which does not have the potential for tax avoidance. See “Excep-tions to Dividend Equivalency,” and “Avoidance of Withholding—Comparison of FATCA to Green Book Proposal.” In making this determination the proposal specified factors which the Treasury may take into account. While the HIRE Act continues to permit the Treasury to identify exceptions from dividend equivalency withholding, it no longer will be based upon a nonexclusive list of factors which the Treasury under FATCA or the Green Book Proposal had been requested to take into account in determining whether a payment has the potential for tax avoidance.

Dividend equivalency withholding based on gross amount. The HIRE Act continues to follow FATCA and provides in new Code Sec. 871(l)(5) the term “pay-ment” includes any gross payment which is used in computing any net amount which is transferred to or from the taxpayer.189

The example of a “total return swap” referencing stock of a domestic corporation (an example of a notional principal contract to which the provisions applies), illustrates the consequences of this rule. Under a typical total return swap, a foreign investor enters into an agreement with a counterparty under which amounts due to each party are based on the returns generated by a notional principal contract in a specified dollar amount f the stock underlying the swap. The investor agrees for a specified period to pay the counterparty (1) an amount calculated by reference to a market interest rate (such as the Lon-don Interbank Offered Rate (LIBOR) on the notional amount of the underlying stock, and (2) any deprecia-tion in the value of stock. In return, the counterparty agrees for the specified period to pay the investor (a) any dividends paid on the stock, and (b) any ap-preciation in the value of the stock.190 Amounts owed by each party under this swap typically are netted so that only one party makes an actual payment.

The provision treats any dividend-based amount under the swap as a payment even though any actual payment under the swap is a net amount determined in part by other amounts (for example, the interest amount the amount of any appreciation or depreciation in value of the referenced stock). Accordingly, a counter party to a total return swap may be obligated to withhold and remit tax on the gross amount of the dividend equivalent even though, as a result of netting of payments due un-der the swap, the counterparty is not required to make an actual payment of the foreign investor.191

Prevention of over-withholding. New Code Sec. 871(l)(6) provides in the case of any chain of dividend equivalents one or more of which is subject to tax under this Section or Code Sec. 881, the Treasury may reduce such tax, but only to the extent that the taxpayer can establish that such tax has been paid with respect to another dividend equivalent in such claim. For purposes of this definition, a dividend will be treated as a dividend equivalent.192

If there is a chain of dividend equivalents (under, for example, transactions similar to those described in Notice 97-66,193 which will now presumably be void after the new provision becomes effective), and one or more of the dividend equivalents is subject to


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tax under the provision or under Code Sec. 881, the Treasury may reduce that tax, but only to the extent that the taxpayer established that the tax has been paid on another dividend equivalent in the chain. An actual dividend is treated as a dividend equivalent for purposes of this rule.194

Control over payment. For purposes of Chapters 3 and 4, each person that is a party to any contract or other arrangement that provides for the payment of a dividend equivalent will be treated as a having control of such payment.195

Treasury authority to provide additional guidance. The new law which is intended to treat dividend equivalents as U.S.-source dividends is not intended to limit the authority of the Treasury (1) to determine the appropriate source of income from financial ar-rangements (including notional principal contracts) under Code Sec. 863 or 865, or (2) to provide additional guidance addressing the source and char-acterization of substitute payments made in securities lending and similar transactions.196

The dividend equivalent provisions of the bill should not be self-executing. The Treasury should consider providing this additional guidance since the dividend withholding rules need more clarity to identify the transactions and products that are abusive, whether called an equity swap, derivative, forward contract, financial contract or goes by another name.

Unfortunately, the new law does not provide taxpay-ers with bright lines rules or examples to determine which transactions will be considered dividend equiv-alents and therefore subject to withholding and those that are not. For example, the identified factors which define a specified notional principal contract do not identify among other considerations, the term of the contracts which will qualify for non-abusive treatment, the amount (fixed or percentile) of each party’s invest-ment or collateral, what is an objectively observable price, the terms that are relevant to analysis of the par-ties hedge position and the relevancy of the intentions of the parties for the sale of the securities giving rise to the dividends which are critical for an exemption from withholding. There is also no articulation about whether one or more of the factors should be weighted more (or less) heavily in making the determination. Importantly, Treasury is directed to consider substan-tially similar transactions with no clear delineation of what is meant by that term in the statute.

Avoid potential double withholding on equity swaps. Under the law, the payments that are treated as U.S. source dividends are the gross amounts that are used

in computing the net amounts transferred to or from the taxpayer. Thus, a withholding tax could be imposed under the new law on a gross basis even if no actual payment was made after the netting. There may still be an issue of possible double withholding because of the way the equity swap business is done at a number of firms. Firms often centralize their swap trading activities in one legal entity to achieve netting benefits for credit and balance sheet purposes. However, the risk for the positions may be managed in a different legal entity so there is a mirror internal swap for each client swap. This mirror creates the potential for double withhold-ing. It is recommended that consideration be given to an exemption for the second withholding tax where the taxpayer can demonstrate to the IRS that an internal mirror situation exists and withholding tax was actually imposed at gross on the first client swap.

Avoid overriding existing U.S. treaties. Many U.S. tax treaties generally permit treaty benefits (e.g., reduced withholding taxes) if a foreign person can establish he or she is “qualified resident” of a treaty jurisdiction based on objective tests. The law may add a new information reporting test not found in our treaties. The law provides that the Secretary has the authority to provide guidance ensuring that taxpay-ers are eligible for treaty benefits and those taxpayers claiming credits or refunds of amounts withheld under the law supplies appropriate documentation establish-ing that they are the beneficial owners of the payments. Where the law conflicts with the treaty, the law may preempt the treaty and override it. As a matter of good tax policy and comity, it is recommended that Treasury make clear that the new law is not intended to override existing treaty provisions.

Effect of the HIRE Act on outstanding equity swaps. The Cadwalader Hire Act Comments had the follow-ing concerns regarding the impact of the new law on outstanding equity swaps:197

If a foreign person has entered into an equity swap under a standard (unmodified) ISDA Master Agree-ment prior to March 18, 2010, and is subject to withholding under the [HIRE] Act on a dividend equivalent payment made on or after September 14 (because, for example, the foreign party trans-ferred stock to its counterparty in connect with the transaction),the foreign counterparty will be entitled to a “gross up” payment that results in the foreign counterparty receiving the same pay-ment it would have received had no amount been withheld. 198 Under the terms of the IDDA Master

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Agreement (unless otherwise modified), a party will be obligated to pay a gross up amount on the next scheduled payment date under the swap (referred to as the Affected Party”) may take the following steps to terminate the swap.199

First, the Affected Party must promptly notify the foreign counterparty of the impending gross-up obligation.200 Second, the Affected party must make reasonable efforts to transfer the swap within 20 days.201 If the Affected Party is un-able to mitigate its gross-up obligation through a transfer within the 20-day period,202 it must notify the foreign counterparty within the 20-day period, and the foreign counterparty than has the option within 30 days to transfer the swap to an affiliate that would not be subject to withholding (e.g., to a U.S. affiliate).203 If the foreign counterparty does not transfer the swap to an affiliate that is not subject to withholding within the 30 day period, the Affected Party may designate a termination date for the swap upon not more than 20 day notice.204

For equity swaps entered into after March 18, 2010, which remain outstanding on September 14, 2010, and (i) involve cross-in or cross-out (ii) with respect to which the underlying stock is not readily tradable on an established securities market (iii) the underlying stock is posted as col-lateral to the foreign party, or (iv) are identified as being subject to withholding prior to the date they were entered into, the foreign party will be entitled to a gross-up, but the counterparty will have the right to terminate the swap.

Notice 2010-46—Securities Lending TransactionsOn May 20, 2010, the IRS issued Notice 2010-46 (the “Notice”) providing the long awaited guidance on sub-stitute dividend payments received by foreign taxpayers that lend U.S. dividend paying securities in a securities lending transaction and revoking Notice 97-66. The Notice outlines a proposed regulatory framework to address potential over withholding that may occur as a result of new Code Sec. 871(l) and provides transi-tion relief with respect to substitute dividend payments made between the September 14, 2010, and the date of the issuance of final regulations anticipated to be effec-tive on and after January 1, 2012. The Notice provides

the framework that the future regulations will take in order to address information reporting and withholding tax for substitute dividend payments.

BackgroundOn October 14, 1997, final regulations were published in the federal register205 that source substitute interest and substitute dividend payments made pursuant to a securities lending transaction described in Code Sec. 1058 or a substantially similar transaction or a sale-repurchase transaction (a “securities lending transaction”) by reference to the income that would be earned with respect to the underlying transferred debt security or stock. The final regulations also provide that substitute interest and dividend payments that are from sources within the United States under the regulations are characterized as interest and dividends for purposes of determining the fixed or determinable annual or periodical income of nonresident alien indi-viduals and foreign corporations subject to tax under Code Secs. 871(a), 881 and 4948(a) and Chapter 3 and for purposes of granting tax treaty benefits with respect to interest and dividends. As promulgated, the final regulations were made applicable in all respects for substitute interest payments (as defined in Reg. §1.861-2(a)(7)) and substitute dividend payments (as defined in Reg. §1.861-3(a)(6)).

Some taxpayers expressed concern that the total U.S. gross basis tax paid with respect to a series of securities lending transactions—that is, a chain of related securities lending transactions with respect to identical securities could be excessive. To permit relief from such cascading taxation, the Treasury Department issued Notice 97-66 which generally limits the aggregate U.S. gross basis tax on a series securities lending transactions, which could give rise to withholding on multiple substitute payments.

Notice 97-66Notice 97-66 provided a formula based approach to calculate the amount of U.S. withholding tax to be imposed on a foreign-to-foreign substitute payment. Under this method, the amount of U.S. withhold-ing tax was the amount of the underlying dividend multiplied by a rate equal to the excess of the rate of U.S. withholding tax that would be applicable to U.S. source dividends paid by a U.S. person directly to the recipient of the substitute payment over the rate of U.S. withholding tax that would be applicable to U.S. source dividends paid by a U.S. person directly to the payor of the substitute payment.206 The Notice


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also stated that the Treasury intended to provide de-tailed guidance on how substitute dividend payments made by one foreign person to another foreign person were to be treated.

For example, if a borrower is eligible for a 15-percent rate under a U.S. tax treaty on U.S. source dividends makes a substitute dividend payment to a lender that is resident in a non-treaty jurisdiction subject to a 30-percent U.S. withholding tax on U.S. source dividends, the amount of tax imposed on the substitute dividend payment gener-ally will be limited to 15 percent (i.e., the payee’s tax rate of 30 percent less the payor’s rate of 15 percent). Notice 97-66 also provides in an example, if a securities lender’s tax liability has already been reduced in prior withholding within a cascading lending transaction that the borrower in its capacity as a withholding agent is permitted to reduce the lender’s liability by such amount.

HIRE Act Provisions— Securities Lending TransactionsIn the JCT Report to the HIRE Act, it was explained that Congress, in enacting new Code Sec. 871(l), was concerned that some taxpayers have taken the position that Notice 97-66 sanctioned the elimination of U.S. withholding tax in certain transactions such as through the use of securities lending transactions.207 New Code Sec. 871(l) provides that certain dividend equivalent payments are treated as U.S.-source dividends effective for payments made on or after September 14, 2010.

The term “dividend equivalent” is defined for this purpose to include “any substitute dividend made pursuant to a securities lending or sale-repurchase transaction that (directly or indirectly) is contingent upon, or determined by reference to, the payment of a dividend from sources within the United States.”208 New Code Sec. 871(l)(6) authorizes the Secretary to reduce tax with respect to a chain of dividend equivalents “but only to the extent that the taxpayer can establish that such tax has been paid with respect to another dividend equivalent in such chain or is not otherwise due or as the Secretary determines is appropriate to address the role of financial intermediaries in such chain.”

When Is Notice 97-66 Withdrawn and Can Taxpayers Continue to Rely upon It?

Notice 97-66 will be withdrawn effective for payments made on or after September 14, 2010. Tax-payers can continue to rely on Notice 97-66 prior to September 14, 2010, except that a withholding agent

or foreign lender may not rely on this guidance if the withholding agent or foreign lender knows or has reason to know that a securities lending transaction or series of such transactions has a principal purpose of reducing or eliminating the amount of gross basis tax that would have been due in the absence of such transaction or transactions.

For example, a person may not rely on Notice 97-66 to reduce or eliminate the amount of U.S. tax on the substitute dividend it is obligated to pay the foreign lender when it structures or participates in an arrangement where it:

borrows shares of a domestic corporation from a foreign person in a transaction described in Code Sec. 1058 after a dividend declaration; sells that stock to a related U.S. person before the ex-dividend date; and enters into a total return swap agreement with that related person in order to hedge its risk.

Notice 2010-46 indicates that no inference is intended as to whether any transaction entered into prior to May 20, 2010 (the date of the Notice), is eligible for the relief described in Notice 97-66, and the IRS may challenge transactions under existing law including by applying existing judicial doctrines.

Query, will the new Code Sec. 7701(o), which “codifies” the “economic substance doctrine,” and became law in March 2010, as part of the Health Care and Education Affordability Reconciliation Act of 2010209 be used by the IRS to challenge securities lending transactions entered into after March 30, 2010, the effective date of the new provision? New Code Sec. 7701(o) provides both a definition of economic substance and a new strict liability penalty that may apply if a taxpayer enters into a transaction that fails to have economic substance. If a tax credit transaction is found to not have “economic substance,” then some or all of the credits and related deductions will be disallowed and either a 20-percent penalty will apply if the transaction is disclosed on the taxpayer’s return or a 40-percent penalty if it is not disclosed.

What Will Be the New Withholding and Reporting Framework for the Final Regulations?

The Notice indicates the Treasury and the IRS intend to issue regulations under its authority described in new Code Sec. 871(l)(6).210 As noted above, these regulations are expected to replace the formulary approach dis-cussed above under Notice 97-66 with a documentation

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based system under which withholding agents will be able to reduce withholding to the extent that withholding is shown to have been made on another substitute pay-ment or dividend with respect to identical securities.

The new withholding and reporting framework will consist of two sets of rules, the qualified securities lender rules and the credit forward rules. In order to reduce instances of potential excessive or cascading taxation and to properly account for the role of finan-cial intermediaries in securities lending transactions, the qualified securities lender rules are expected to exempt certain eligible foreign financial institutions from being subject to withholding on receipt of sub-stitute dividend payments provided that they assume responsibility and liability for properly withholding, reporting, depositing and paying U.S. tax with respect to substitute dividend payments.

The credit forward rules will be applicable if the qualified securities lender rules do not otherwise apply and will permit a withholding agent to reduce the withholding on amounts previously withheld on a substitute dividend payments provided there is suf-ficient evidence that the tax was actually withheld. However, the Notice indicates the IRS can administer compliance by participants by disqualifying noncom-pliant taxpayers from eligibility for the relief provided in this Notice in appropriate cases.

What Is the “Qualified Securities Lender” Framework?What is the tax treatment for withholding agent? Under the regulations to be issued, a withholding agent making a substitute dividend payment to a for-eign financial institution that is a “qualified securities lender” will not be required to withhold U.S. tax with respect to such payment provided the withholding agent obtains the required certifications from such institution. See “What Certifications Are Required by a Qualified Securities Lender?”

What certifications are required by a qualified se-curities lender? The regulations are expected to relieve a withholding agent of its liability to withhold U.S. tax with respect to any substitute dividend paid to a qualified securities lender only if the withholding agent receives a written certification from the qualified securities lender either on a form prescribed by the IRS or as otherwise provided by regulation. This certification must include a statement that the recipient of a substitute dividend is a qualified securities lender and that with respect to any substitute dividend it receives from the withholding agent it will withhold and remit or pay the proper amount of

U.S. gross basis tax with respect to substitute dividend payments that it receives or makes.

What is the tax treatment for a qualified securities lender? Rather, it is anticipated that these regula-tions will impose the withholding obligation on the qualified securities lender and also coordinate the obligation of a qualified securities lender to withhold on substitute dividend payments that it makes, pay and deposits tax on substitute dividends it receives, and report on substitute dividends it makes (on behalf of itself or any other person). The new regulations are expected to define these obligations in terms of two distinct categories of substitute dividends that quali-fied securities lenders pay or receive.

Will a qualified securities lender have to withhold where it receives and pays a substitute dividend pay-ment? In circumstances where a qualified securities lender receives a substitute dividend payment (the “first substitute dividend payment”) and is obligated to make an offsetting substitute dividend payment with respect to identical securities (the “second substitute dividend payment”), a qualified securities lender will not be liable for U.S. withholding tax on the first substitute dividend payment under Code Sec. 871(a) or 881(a), but must properly withhold under Code Secs. 1441 and 1442 and report with respect to the second substitute dividend payment.

In circumstances where a qualified securities lender receives a substitute dividend payment for which it has no obligation to make an offsetting substitute dividend payment with respect to identical securities, the qualified securities lender remains liable for tax under Code Sec. 871(a) or 881(a) by virtue of the receipt of such substitute dividend payment as the beneficial owner of such payment.

Is there an anti-abuse rule for structures which facilitate the avoidance of tax? The IRS intends to monitor qualified securities lenders for compliance with the rules described in the Notice and may revoke an institution’s status as a qualified securities lender for noncompliance. For example, circumstances in which an institution structures or participates in ar-rangements designed to facilitate the avoidance of U.S. gross basis taxation by foreign persons that hold or held U.S. equities, as well as circumstances in which an institution does not withhold and deposit tax at the proper rate when it acts as a custodian on behalf of both a borrower and lender in the same securities lending transaction.

What is the definition of a “qualified securities lender”? For purposes of the relief described above,


September 2010

the regulations are expected to provide that a foreign financial institution is a qualified securities lender only if it satisfies all of the following conditions:

It is a bank, custodian, broker-dealer, or clear-ing organization that is subject to regulatory supervision by a governmental authority in the jurisdiction in which it was created or organized, and is regularly engaged in a trade or business that includes the borrowing of securities of domestic corporations (as defined in Code Sec. 7701(a)(4)) from, and lending of securities of domestic corporations to, its unrelated customers. It is subject to audit and summons power by the IRS under Code Sec. 7602 or in the case of a qualified intermediary (QI) that appropriately amends its QI agreement with the IRS, by an external auditor. It is likely further guidance will specify the require-ments of such an amendment to the QI agreement. In general, however, the amendment will require the QI to report, withhold, deposit, and pay U.S. tax. See “What Are the Information Reporting Re-quirements for Substitute Payments?” It files an annual statement on a form prescribed by the IRS certifying that it satisfies the conditions necessary to be a qualified securities lender. See “What Certifications Are Required by a Qualified Securities Lender?”

What Is the Credit Forward Framework?According to the Notice, the Treasury and the IRS believe that the vast majority of instances of exces-sive or cascading taxation arising in connection with substitute dividend payments will be relieved through the qualified securities lender rules. To address the remaining instances of excessive or cascading taxation not addressed by the qualified securities lender rules, the regulations are expected to provide a document based credit forward system.

Will there be a credit or relief for prior withhold-ing? The regulations are expected to provide that a withholding agent may limit the aggregate U.S. gross basis tax within a series of securities lending trans-actions to the amount of U.S. gross basis tax, if any, applicable to the foreign taxpayer (other than in the case of a qualified securities lender that is obligated to make an offsetting substitute dividend payment) bear-ing the highest rate of U.S. gross basis tax on either a substitute or actual dividend with respect to the un-derlying security transferred in the series. As a result, the aggregate taxes paid in such transactions should

not exceed the 30-percent statutory rate applicable to U.S. source dividends paid to foreign persons.

The regulations are also expected to provide that a withholding agent may relieve excessive tax on substitute dividends by reducing withholding on a substitute dividend payment that the withholding agent is obligated to make by an amount not to exceed the amount that has been previously withheld within the same series of securities lending transactions, but only to the extent that there is sufficient evidence that tax was actually withheld on a prior dividend and/or substitute dividend paid to the withholding agent or a prior withholding agent within the same such series.

No payee in a series of securities lending transac-tions may claim a refund (or claim a credit against any other liability) solely because a prior payee in the same series was subjected to a higher rate of gross basis U.S. tax. Moreover, no taxpayer or withholding agent in a series of securities lending transactions may credit any tax withheld with respect to a substitute dividend payment in such series against any tax imposed with respect to a substitute dividend payment in a different series of Securities Lending Transactions.

How can evidence of prior withholding be sub-stantiated? The regulations are expected to provide that sufficient evidence of prior withholding will be deemed to exist where there is written documenta-tion that identifies amounts previously withheld by another withholding agent with respect to actual dividend distributions or substitute dividends in the same series of securities lending transactions or as otherwise prescribed by the IRS in future guidance.

For example, the regulations are expected to provide that a withholding agent may presume that tax has been withheld by a prior withholding agent in a series of securities lending transactions if that agent (i) receives a substitute dividend net of U.S. withholding taxes, (ii) receives a written statement from the immediately prior withholding agent setting out the amount of such taxes, (iii) identifies the person who withheld such tax and the recipient of the payment against which such tax was withheld, and (iv) does not know or have reason to know that the written statement is unreliable. For these determinations, a withholding agent may not rely upon evidence of a sale of the underlying security as a basis to determine that tax has been paid or withheld.

Is there an anti-abuse rule? Finally, the regula-tions are expected to provide a separate anti-abuse rule which will provide that a withholding agent or a qualified securities lender may not rely on any of the foregoing rules (including any certifications

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provided by a qualified securities lender) when the withholding agent or qualified securities lender knows or has reason to know that a securities lending transaction, or series of such transactions, has a principal purpose of reducing or eliminating the amount of U.S. gross basis tax that would have been due in the absence of such transaction or transactions. In such a case, a withholding agent or qualified securities lender must withhold and the recipient of such payment is subject to U.S. tax at 30 percent (subject to reduction under an applicable income tax treaty) on each substitute dividend pay-ment with respect to such transaction.

What Are the Information Reporting Requirements for Substitute Payments?

In cases in which a withholding agent (including a qualified securities lender) makes a substitute dividend payment and in reliance on the regulations reduces the withholding or is exempted from withholding, the with-holding agent should include on Form 1042 and Form 1042-S the gross amount of the substitute dividend payment to which the recipient would have otherwise been entitled before consideration of any withholding tax obligations and the amount of tax withheld by the withholding agent and shown to have been withheld by other withholding agents in the series of securities lending transactions based on the documentation and information as described above.

In addition, a withholding agent (including a quali-fied securities lender) that makes a substitute dividend payment to a U.S. person will be required to report and withhold to the extent required under Chapter 61 and Code Sec. 3406. Thus, if a withholding agent or qualified securities lender makes a substitute divi-dend payment and is either exempt from withholding or withholds at a reduced rate the withholding agent will report on Form 1042 and Form 1042-S the gross amount of the substitute dividend payment and the amount of U.S. tax withheld by it or other withholding agents in the series of securities lending transactions.

What Are the Transitional Rules for the Period from September 15, 2010, Until January 1, 2012?

The Treasury and the IRS anticipate that the regula-tory framework outlined above will be effective for transactions entered into on or after January 1, 2012.

Until such regulations are issued and after September 14, 2010 (the “transition period”), Code Sec. 871(l) will apply with the potential for U.S. tax due on a series of securities lending transactions that exceeds 30 percent in the aggregate. In order to avoid exces-sive or cascading tax in these situations, withholding agents may rely on the transition rules which adopt a modified qualified securities lender framework.

Under this framework a withholding agent will not be required to withhold if it receives an annual certification from the counterparty that substantially complies with the above certification requirements, is an eligible foreign financial institution and is subject to audit and summons power of the IRS or is a quali-fied intermediary that is subject to audit by an external auditor. This certification must include a statement that the recipient of a substitute dividend is a qualified securities lender and that with respect to any substitute dividend it receives from the withholding agent it will withhold and remit or pay the proper amount of U.S. gross basis tax with respect to substitute dividend payments that it receives or makes.

The maximum aggregate U.S. gross basis tax due, if any, with respect to a series of securities lending transactions and any related dividend payment is the amount determined by the tax rate paid by the foreign taxpayer (other than in the case of a quali-fied securities lender that is obligated to make an offsetting substitute dividend payment) bearing the highest rate of U.S. gross basis tax in the series. Ac-cordingly, the aggregate U.S. gross basis taxes paid in such transactions generally should not exceed the 30-percent statutory rate applicable to U.S.-source dividends paid to foreign persons.

What presumptions can a withholding agent rely upon to establish a U.S. tax has been paid on sub-stitute dividend payments? A withholding agent that is obligated to make a substitute dividend payment pursuant to a securities lending transaction may presume that U.S. tax has been paid in an amount equal to the amount implied by the net payment if all of the following are satisfied:

The withholding agent receives a substitute dividend or dividend payment with respect to identical securities that reflects a reduction for withholding of U.S. gross-basis tax.The withholding agent does not know or have reason to know that tax was not withheld and deposited or paid. For this purpose, a withholding agent has a reason to know that tax was not with-held if, for example, the amount of any lending


September 2010

fee or similar fee is increased directly or indirectly in whole or in part by the difference between the gross amount of the substitute dividend and the net amount received.The withholding agent is a person subject to audit under Code Sec. 7602, or in the case of a QI, by an external auditor.

Can a payee claim a refund or credit if a prior payee was subject to a higher rate of tax than the current payee? No payee in a series of securities lending trans-actions may claim a refund (or claim a credit against any other liability) solely because a prior payee in the same series was subjected to a higher rate of gross basis U.S. tax. Moreover, no taxpayer or withholding agent in a series of securities lending transactions may credit any tax withheld with respect to a substitute dividend payment in such series against any tax imposed with respect to a substitute dividend payment in a different series of securities lending transactions.

How will the qualified securities lender rules apply during the transitional period? During the transition period, a withholding agent may adopt a system that reasonably implements the principles of the quali-fied securities lender system. In particular, during the transition period, a withholding agent is not required to withhold on a substitute dividend payment made to a qualified securities lender if the withholding agent receives, at least annually, a statement from its counter-party that substantially complies with the certification requirement. A foreign financial institution may make such a certification only if it reasonably determines that it meets the requirements to qualify as a qualified securities lender (without regard to the requirement that a qualified securities lender file an annual state-ment with the IRS). It is anticipated that future guidance will provide that all qualified securities lenders taking advantage of the transition relief may be required to identify themselves to the IRS (in a manner to be speci-fied) before the end of 2010. A QI that provides such a certification will be deemed to have agreed to amend its QI agreement for these purposes as necessary to report, withhold, deposit and pay U.S. tax.

Is there a kick-out rule for purposes of the transitional rules? Withholding agents may not rely on this transition relief with respect to a securities lending transaction or series of such transactions that are entered into with a principal purpose of reducing or eliminating the ag-gregate amount of U.S. tax that would have been due in the absence of such transaction or series of transac-tions. A foreign financial institution that is determined to have structured or engaged in one or more of the

above transactions on or after May 20, 2010, will not qualify as a qualified securities lender for a period of five years from the date of such determination.

What methods can a qualified securities lender use to determine the securities which have actually been borrowed and lent? A qualified securities lender may use any reasonable method, consistently applied, to determine which securities within a pool of fungible securities available to borrow have actually been bor-rowed and lent. Withholding agents will be required to perform information reporting.

Will a withholding agent be entitled to an exten-sion to file information returns for 2010? To the extent that Code Sec. 871(l) applies to any substitute dividend payments in respect of any transaction de-scribed in Code Sec. 871(l)(2)(A), withholding agents will be granted an automatic six-month extension of time to file information returns such as Form 1042 and Form 1042-S pursuant to Reg. §1.1461-1(c) with respect to the 2010 calendar year.

However, the time for filing information returns pursuant to Reg. §1.1461-1(c) shall not be extended beyond the date on which the withholding agent provides a copy of the return to the recipient. In addi-tion, withholding agents will be granted an automatic extension for making deposits of withheld tax from such substitute dividend payments until January 31, 2011, for the 2010 calendar year.

What are the effective dates of the notice? The modification of Notice 97-66 is effective for amounts paid on or after May 20, 2010, and before Septem-ber 14, 2010. The transition rules are effective for amounts paid on or after September 14, 2010.

Has the government requested comments in connection with the new regulations? The Treasury and the IRS have requested comments on the fol-lowing issues:

The definition of a qualified securities lenderThe treatment of substitute dividends paid to a qualified securities lender where that entity holds the relevant position in a proprietary accountWhether additional rules are required to address abusive securities lending transactions that avoid U.S. tax in addition to the anti-abuse regulation discussed aboveThe treatment of substitute dividends paid with re-spect to securities transferred from a commingled account containing securities held by a qualified securities lender in its proprietary capacity and other securities held in connection with transac-tions for customers

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Whether a qualified intermediary with qualified securities lender status (a “Lender QI”) should be required to provide the withholding rate pool information of its customers to another qualified intermediary (a “Borrower QI”) that has borrowed securities in a securities lending transactionWhether a Borrower QI should be required to withhold and carry out information reporting on a substitute dividend payment made to a Lender QI based upon the withholding information provided by a Lender QI with respect to its customersThe definition of a series of securities lending transactions, and how related securities loans in a series should be identified, including appropriate methods pursuant to which a qualified securities lender may determine which securities within a pool of fungible securities are attributable to particular securities lending transactions

Will the qualified securities lender framework ap-ply to substitute interest payments? At present, it is an open question whether these new rules will apply to substitute interest payments.

Repeal of Certain Foreign Exceptions to Registered Bond RequirementsBackgroundIn general, a taxpayer may deduct all interest paid or accrued within the tax year on indebtedness.211 For registration-required obligations, a deduction for interest is allowed only if the obligation is in registered form. Generally, an obligation is treated as issued in registered form if the issuer or its agent maintains a registration of the identity of the owner of the obligation and the obligation can be transferred only through this registration system.212

A registration-required obligation is any obligation other than one that (i) is made by a natural person, (ii) matures in one year or less, (iii) is not of a type offered to the public, or (iv) is a foreign targeted obligation.213

In applying this requirement, the IRS has adopted a flexible approach that recognizes that a debt obligation that is formally in bearer (i.e., not in registered) form is nonetheless “in registered form” for these purposes where there are arrangements that preclude individual investors from obtaining definitive bearer securities or that permit such se-curities to be issued only upon the occurrence of an extraordinary event.214

A foreign targeted obligation to which the registra-tion requirement does not apply is any obligation satisfying the following requirements:

there are arrangements reasonably designed to ensure that such obligation will be sold (or resold in connection with the original issue) only to a person who is not a U.S. person, interest is payable only outside the United States and its possessions, and the face of the obligation contains a statement that any U.S. person who holds this obligation will be subject to limitations under the U.S. in-come tax laws.215

In addition to the denial of an interest deduction, an excise tax is imposed on the issuer of any registration-required obligation that is not in registered form.216 The excise tax is equal to one percent of the principal amount of the obligation multiplied by the number of calendar years (or portions thereof) during the period beginning on the date of issuance of the obligation and ending on the date of maturity.

Moreover, any gain realized by the beneficial own-er of a registration-required obligation that is not in registered form on the sale or other disposition of the obligation is treated as ordinary income (rather than capital gain), unless the issuer of the obligation was subject to the excise tax described above.217 Finally, deductions for losses realized by beneficial owners of registration-required obligations that are not in a registered form are disallowed.218

For the purposes of ordinary income treatment and denial of deduction for losses, a registration-required obligation is any obligation other than one that (i) is made by a natural person, (ii) matures in one year or less, or (iii) is not of a type offered to the public.

Treatment as portfolio interest. Payments of U.S. source “fixed or determinable annual or periodical” income, including interest, dividends and similar types of investment income, that are made to foreign persons are subject to U.S. withholding tax at a 30-percent rate, unless the withholding agent can establish that the beneficial owner of the amount is eligible for an exemption from withholding or a reduced rate of withholding under an income tax treaty.219 In 1984, Congress repealed the 30-percent tax on portfolio in-terest received by a nonresident individual or foreign corporation from sources within the United States.220

The term “portfolio interest” means any interest (including original issue discount) that is:

paid on an obligation that is in registered form and for which the beneficial owner has provided to the


September 2010

U.S. withholding agent a statement certifying that the beneficial owner is not a U.S. person; or paid on an obligation that is not in registered form and that meets the foreign targeting requirements of Code Sec. 163(f)(2)(B).221

However, portfolio interest does not include inter-est received by a 10-percent shareholder,222 certain contingent interest,223 interest received by a controlled foreign corporation from a related person224 or interest received by a bank on an extension of credit made pursuant to a loan agreement entered into in the ordinary course of its trade or business.225

Requirement that Treasury obligations be in reg-istered form. Under Title 31 of the U.S. Code, every “registration-required obligation” of the Treasury must be in registered form.226 For this purpose, a foreign targeted obligation is excluded from the definition of a registration-required obligation.227 Thus, a foreign targeted obligation of the Treasury can be in bearer (rather than registered) form. Neither the Levin Bill nor the Green Book Proposal for 2010 contained provisions repealing the exceptions to the above-described registered bond requirements.

FATCA: Section 102—Repeal of certain foreign exceptions to registered bond requirements—Repeal of the foreign targeted obligation exception to the registration requirement. The provision repeals the foreign targeted obligation exception to the denial of a deduction for interest on bonds not issued in registered form. Thus, under the provision, a deduction for inter-est will be disallowed with respect to any obligation not issued in registered form, unless that obligation (i) is issued by a natural person, (ii) matures in one year or less, or (iii) is not of a type offered to the public.

In addition, under the provision, the foreign target-ed obligation exception is not available with respect to the excise tax applicable to issuers of registration-required obligations that are not in registered form. Thus, the excise tax generally applies with respect to any obligation that is not in registered form un-less the obligation (i) is issued by a natural person, (ii) matures in one year or less, or (iii) is not of a type offered to the public.

Further, under the provision, the foreign targeted ob-ligation exception will not be available with respect to the ordinary income treatment of any gain realized by the beneficial owner of a registration-required obliga-tion that is not in registered form on the sale or other disposition of the obligation. Thus, any gain realized upon the sale or other disposition of an obligation that is not in registered form is treated as ordinary income

(rather than capital gain), unless the obligation (i) is is-sued by a natural person, (ii) matures in one year or less, or (iii) is not of a type offered to the public, or the issuer of the obligation was subject to the excise tax described above. The provision includes a conforming change to Title 31 of the U.S. Code that repeals the foreign targeted exception to the definition of a registration-required obligation. Thus, a foreign targeted obligation of the U.S. government must be in registered form.

Repeal of treatment as portfolio interest. The provi-sion repeals the treatment as portfolio interest of interest paid on bonds that are not issued in registered form but meet the foreign targeting requirements of Code Sec. 163(f)(2)(B). Under the provision, interest qualifies as portfolio interest only if it is paid on an obligation that is issued in registered form and for which the benefi-cial owner has provided the withholding agent with a statement certifying that the beneficial owner is not a U.S. person. Thus, under the provision, interest paid to a foreign person on an obligation that is not issued in registered form is subject to U.S. withholding tax at a 30-percent rate, unless the withholding agent can establish that the beneficial owner of the amount is eligible for another exemption from withholding or a reduced rate of withholding under an income tax treaty.

Effective date. The provision applies to debt obliga-tions issued after the date which is 180 days after the date of enactment.

The bearer bond provisions of the law should not be self-executing. Congress determined over 25 years ago that U.S. individuals holding bearer bonds in foreign accounts created the potential for tax evasion and determined that new laws needed to be enacted to prevent U.S. individuals from holding such assets. At that time, Congress was also aware that the Euro-dollar market was primarily a bearer bond market and an important source of debt financing for many U.S. corporate borrowers. The current law and regulations adopted a flexible approach to the problem and permitted issuers to issue bearer bonds outside the United States in capital markets that are either customary or required, while setting up rules designed to ensure their sale to only non-U.S. persons under the foreign-targeted obligation rules.

FATCA would require these bonds to be in regis-tered form and repealed the so-called TEFRA C and TEFRA D bearer bonds issued 180 days after enact-ment. These bearer bonds would have been subject to a one-percent excise tax on the principal amount each year and interest on such bonds would no lon-ger be subject to the portfolio interest exemption to

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avoid the U.S. withholding tax. The collateral impact of this change would have been to treat any gain recognized on the disposition of these bearer bonds as ordinary income, unless the excise tax was paid and any losses would be disallowed.

Some commentators have suggested the FATCA has the potential to disrupt global debt markets unless the provision is subject to the promulgation of Treasury regulations and guidance as to how the new rules will be applied. For example, by removing the foreign-targeted obligation rules, the Bill has the unintended consequence of making all foreign issuers of bearer bonds subject to a likely unenforceable U.S. excise tax. In addition, any foreign debt of U.S. middlemen (e.g., a London branch of a U.S. financial institution) would result in U.S. information reporting requirements even though both the issuer and investors are non-U.S. persons. Lastly, there are concerns that bearer bonds issues that are subject to this rule have already been (or are being marketed) to foreign investors on the basis that no U.S. excise tax or withholding tax will apply.

ABA Tax Section Comments on FATCA—Repeal of the foreign targeted obligation exception for bearer bonds (Section 102 of the bill). The ABA Tax Section Comments on FATCA recommended that (i) Congress authorize the Treasury to allow issuers to issue foreign targeted bearer obligations in one or more specified jurisdictions, subject to periodic review if a specified jurisdiction is determined to be important to capital markets and that meeting the registration requirements under established local practice is not feasible; (ii) for-eign issuers, other than, generally, controlled foreign corporations or partnerships or disregarded entities owned by U.S. persons, issuing foreign targeted bearer bonds not be subjected to the Code Sec. 4701 excise tax; and (iii) the effective date for the bearer bond exception from FATCA withholding be consistent with the effective date repeal of the current statutory exception for foreign targeted obligations.228

Background. More specifically, the ABA Tax Section Comments provide:229

Under present law, a “registration-required” obligation that is not issued in registered form generally carries with it punitive tax consequences for both the issuer and the holder: the issuer cannot deduct interest paid or accrued on the obligation and must pay an excise tax equal to one percent of the principal amount of the obligation multi-plied by the number of calendar years (or portions thereof) from the date of issuance to the date of

maturity; interest paid on the obligation does not qualify for the portfolio interest exemption to the 30-percent withholding tax on U.S.-source interest imposed by Code Sec.s 871 and 881; and any loss recognized on the sale or other disposition of the obligation is disallowed to its holder.

When these provisions were enacted over 25 years ago, Congress determined that U.S. individuals holding bearer bonds created the potential for tax evasion. Congress was also aware, however, that certain markets were primarily bearer bond markets and an important source of debt financing for many U.S. corporate borrowers. The current law and reg-ulations therefore adopted a flexible approach to the problem and permitted issuers to exempt from the registration requirement bearer bonds that are “foreign targeted obligations.” As noted in the Joint Committee explanation, in applying this require-ment, the IRS has adopted a flexible approach that recognizes that a debt obligation that is formally in bearer (i.e., not in registered) form is nonetheless “in registered form” for these purposes when there are arrangements that preclude individual investors from obtaining definitive bearer securities or that permit such securities to be issued only upon the occurrence of an extraordinary event.230

Obligations are “foreign targeted” if there are ar-rangements reasonably designed to ensure that the obligation will be sold (or resold in connection with the original issue) only to non-U.S. persons; interest is payable only outside the United States and its possessions; and the face of the obligation contains a statement that any U.S. person holding the obligation will be subject to limitations under U.S. tax laws. The so-called TEFRA C and TEFRA D regulations currently specify detailed rules for meeting these requirements.231

Summary of provision. Under section 102(c) of the Bill, the exception for foreign targeted obligations would be repealed. Thus, foreign tar-geted obligations would be registration-required obligations and, therefore, subject to the above penalty in the case of an issuer and additional tax consequences for the issuer and holders, unless issued in registered form.232

Obligations that are made by a natural person, that mature in one year or less or that are not of a


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type offered to the public, which are currently ex-cepted from the registration requirement, would be unaffected by the repeal of the exception for foreign targeted obligations.

Repeal would be effective for debt obligations issued more than 180 days after the date of en-actment. However, because FATCA withholding would apply under section 101 of the Bill to U.S.-source payments made after December 31, 2010, on bearer bonds issued after the date of first committee action on the Bill, the effective date for the repeal and the effective date for FATCA withholding do not coincide.

Comments. We generally believe that the repeal of the foreign targeted exception is a reasonable measure in light of the overall purpose of the Bill. It would be inconsistent with the approach of sec-tion 101 of the Bill to continue to allow the use of bearer instruments, notwithstanding that they are structured to meet the foreign targeting rules. Accordingly, if the approach in section 101 of the Bill is adopted, then from a consistency standpoint the effective elimination of U.S. issuers from the bearer instrument market as a result of the with-holding tax and sanctions for registration-required obligations makes sense as a general rule. We note, however, the following considerations.

The repeal seemingly would increase, at least to some extent, borrowing costs of affected is-suers. This is because there appear to be still, at least for the time being, certain markets in which it is not feasible to issue instruments in registered form (or in bearer form but under arrangements causing them to meet the regis-tered form requirements for U.S. tax purposes, or when they are issued in registered form but the necessary W-8BEN compliance is not feasible). We are not qualified to express a view on what additional cost may be entailed, which may in any given case differ depending on whether the funds are needed locally or used globally. A possible approach to address this issue would be to authorize Treasury to allow issuers to continue to issue foreign targeted bearer obligations in a specified ju-risdiction or jurisdictions that are determined to be important to the capital markets and in which meeting the registration requirement is

not feasible, subject to periodic review of the continued need for an exception. As currently drafted, the repeal would apply to all issuers, wherever located, resident or organized, including all non-U.S. issuers. The repeal would therefore on its face apply the Code Sec. 4701 excise tax to non-U.S. issuers that issue foreign targeted bearer bonds with-out any connection to interstate commerce. Even if the excise tax in such cases might not be enforced as a practical matter, we recom-mend that, subject to specific exceptions as described in paragraph 3 below, the excise tax be made inapplicable to non-U.S. issu-ers issuing foreign targeted obligations. We believe that it would not be unreasonable to subject certain U.S.-owned issuers to the excise tax on the issuance of bearer form obligations (other than in excepted markets as described in paragraph 1 above). Specifi-cally, the foreign issuers that we recommend for exemption from the excise tax would not include disregarded entities owned by U.S. persons or, in general, controlled foreign corporations within the meaning of Code Sec. 957233 or controlled foreign partnerships within the meaning Code Sec. 6038(a)(5) or their respective disregarded subsidiaries. The inconsistency in effective dates noted above would in effect prohibit the issuance of foreign targeted bearer bonds after the date of first committee action, which is earlier than the effective date for section 102 of the Bill. We believe that this is an unintended incon-sistency, and the effective date for FATCA withholding and reporting on newly issued bearer bonds should be conformed to the effective date for the repeal of the exception for foreign targeted bearer bonds. That is, we believe the exemption from Section 101 of the Bill should apply to bearer bonds issued prior to 180 days after date of enactment and not merely payments prior to January 1, 2011.

SIFMA Comments on FATCA. The SIFMA Tax Com-ments on FATCA recommended that (i) the repeal of the foreign-targeted bearer bond exception be deferred until it can be studied further, and (ii) the grandfather rule is simplified and extended for exist-ing registered debt.234 More specifically, the SIFMA Tax Comments on FATCA provide:235

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Defer repeal of the foreign-targeted bearer bond exception until it can be studied further. The con-sequences of the repeal of the foreign-targeted bearer bond exception should be subjected to further study before such exception is repealed, in order to prevent restricting U.S. issuers’ access to non-U.S. markets. Additionally, the disparity between the repeal’s effective date and the effec-tive date of the new information reporting and withholding rules should be eliminated.236

Since 1982, the “TEFRA” rules generally have al-lowed U.S. issuers to issue debt obligations in bearer form, so long as the obligations are issued under “arrangements reasonably designed to ensure” their sale to non-U.S. persons (the “foreign-targeted bearer bond exception”). The Bill would repeal this exception to the registration requirement.

SIFMA believes that the repeal of the foreign-tar-geted bearer bond exception may restrict access to a number of non-U.S. markets in a manner that would adversely affect U.S. borrowers. In a number of markets, securities traditionally have been issued in bearer form. In some of those mar-kets (e.g., Japan), it may not be feasible to issue securities in registered form, or there may not be sufficiently well developed mechanisms in place to permit the effective collection of Form W-8s. Thus, U.S. issuers would be unable to issue debt in such markets under the Bill, or would be able to do so only in a manner that causes interest on the obligations to be subject to withholding tax at a 30 percent rate, effectively precluding them from raising funds in these markets. In addition, even in markets in which it is feasible to issue securities in registered form, the transition to such issuances may create substantial market disrup-tions if it is not the current market norm.

In this regard, it is worth noting that most bearer bonds are currently bearer in only a very tech-nical sense, since most beneficial interests in such bonds are held through Euroclear or other book-entry clearing systems. As a consequence, it seems unlikely that such instruments would pose any special risks of tax evasion under the Bill, since the information reporting and with-holding provisions of the Bill could generally be applied to payments in respect of such securities in the same manner as for payments in respect of

registered bonds (in each case for bonds issued after the applicable grandfather date).

In order to prevent unwarranted disruption to the borrowing ability of U.S. issuers in situations where the risk of U.S. tax evasion seems miniscule, SIFMA recommends that the Congress direct the Treasury Department to study the potential consequences of the repeal of the foreign-targeted bearer bond exception and prepare a report regarding such a repeal before any action is taken. In this regard, one alternative to a complete repeal that the Treasury Department might wish to consider would be a more limited prohibition that focused solely on bearer bonds in definitive form (i.e., those not held through Euroclear or other book-entry clearing systems).

In addition to the foregoing considerations, there appears to be an inadvertent glitch in the effective date provisions of the Bill relating to the repeal of the foreign-targeted bearer bond exception. In general, the repeal of the foreign-targeted bearer bond exception would be effective for obligations issued more than 180-days after the date of the Bill’s enactment. The new information reporting and withholding rules, however, would apply to any bearer-form obligation that is issued by a U.S. issuer after the date of first Committee action. As a consequence, the Bill would create two categories of U.S.-issued bearer bonds, one that is subject to the new information reporting and withholding regimes and one that is not. SIFMA believes that this result was not intended, and suggests that, if the repeal of the foreign-targeted bearer bond excep-tion is retained, the effective date of the information reporting and withholding rules should be con-formed, by grandfathering bearer-form obligations issued prior to the effective date of the repeal of the foreign-targeted bearer bond exception.”

Simplify and extend the grandfather rule for ex-isting registered debt. To avoid market confusion and disruption, the grandfather rule for existing registered debt should be simplified and extended to exempt all registered debt instruments that are outstanding on the effective date of the new information reporting and withholding regimes and that contain an issuer gross-up provision.237

The FFI and FE information reporting and with-holding regimes are proposed to be effective for


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all registered form debt instruments of U.S. issuers, unless the debt is outstanding on the date of first Committee action and includes a provision under which the issuer would be obligated to make gross-up payments by reason of the Bill. This grandfather provision has already led to substantial market uncertainty as to whether many instruments will or will not be eligible for its protection, and would be very difficult for withholding agents to apply. As one example, gross-up provisions frequently allow an issuer to elect either to make a required gross-up payment or to redeem a debt instrument early. In such a case, it may be questioned whether the issuer is “obligated” to make gross-up payments for purposes of the grandfather provision. As another example, gross-up provisions frequently contain carve-outs for withholding taxes that would not be imposed but for a failure by a holder or beneficial owner of an instrument to make a certification or comply with information reporting requirements. In such a case, because the information reporting obligations contemplated by the Bill would apply to intermediaries in a chain of ownership that may not be holders or beneficial owners for purposes of the gross-up provision, it may be questioned in some instances whether a failure to enter into an information reporting agreement with the IRS under the Bill constitutes such a failure, and whether the issuer would be required to make gross-up pay-ments for purposes of the grandfather provision.

More generally, SIFMA notes that many large U.S. financial institutions and other U.S. issuers derive billions of dollars of funding through debt issuances to foreign investors. In some cases (e.g., debt issuances to foreign retail investors), it may be impossible to effect issuances while the ap-plication of the new information reporting and withholding provisions of the Bill remain uncertain, because the issuance structures will not tolerate the uncertainty—either as a reputational matter for the issuer and underwriters or oftentimes as a local securities law matter—that an intermediary in a chain of payments could fail to comply with the information reporting provisions of the Bill with the result that a foreign investor would suffer a withholding tax through no fault of its own. If the grandfather rule for registered debt contained in the Bill continues to apply only up to the date of first Committee action, U.S. issuers may accordingly be required to cease some or all of their registered

debt issuances in foreign markets after that date until uncertainties regarding the application of the information reporting and withholding provisions of the Bill are resolved.

If retained in its current form, SIFMA anticipates that the grandfather rule for existing registered debt could lead to substantial market confusion and disruption. In order to minimize such confusion and disruption, and the legal and other disputes be-tween issuers, holders, and withholding agents that could result, SIFMA recommends that the grandfa-ther rule for existing registered debt be simplified and extended to exempt all registered debt instru-ments that are outstanding on the effective date of the new information reporting and withholding regimes and that contain an issuer gross-up provi-sion, regardless of whether that gross-up provision would in fact be triggered by the Bill. Because even this simplified grandfather rule would place substantial compliance burdens on withholding agents needing to determine the status of numer-ous debt instruments, SIFMA further recommends that withholding agents be permitted to presume that a registered debt instrument outstanding on the grandfather date qualifies for the grandfather rule, unless the withholding agent knows or has reason to know that it does not qualify.”

Green Book 2011 Proposal—Repeal certain exceptions to registered bond requirements. Al-though the 2010 Green Book Proposal did not have a provision equivalent to this proposal, the Green Book 2011 Proposal related to registered bonds238 appears to be equivalent to the proposals in the HIRE Act enacted into law. See “HIRE Act: Section 502—Repeal of certain foreign exceptions to regis-tered bond requirements.”

HIRE Act: Section 502—Repeal of certain foreign exceptions to registered bond requirements—Repeal of the foreign targeted obligation exception to the registration requirement. The new law makes a fundamental change to existing law by repealing the current exemption to the TEFRA rules for “for-eign-targeted obligations,” which will impact both holders and issuers. More specifically, the new law repeals the foreign targeted obligation exception to the denial of a deduction for interest on bonds not issued in registered form. Thus, under the new law, a deduction for interest is disallowed with respect to any obligation not issued in registered form, unless

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that obligation (i) is issued by a natural person, (ii) matures in one year or less, or (iii) is not of a type offered to the public.

This denial of the interest expense deduction can be expected to severely limit if not end the issuance of bearer bonds by U.S. issuers other than in dematerial-ized form (which will not be treated as bearer debt for U.S. tax purposes). See “Dematerialized book-entry systems treated as registered form.”

According to at least one commentator,239 this denial may also limit the issuance of bearer bonds by controlled foreign corporations (CFCs) because CFCs will not be able to decrease their earnings and profits by the amount of the interest expense and upon (actual or deemed) repatriation of funds from the CFC to its U.S. parent, an amount equal to the interest on bearer bonds will in effect be treated as a taxable dividend to the CFCs.

However, the law preserves the ordinary income treatment under present law of any gain realized by the beneficial owner from the sale or other disposi-tion of a registration-required obligation that is not in registered form. Similarly, the law does not change the present law rule disallowing deductions for losses re-alized by a beneficial owner of a registration-required obligation that is not in a registered form.

Preservation of exception to the registration re-quirement for excise tax purposes. In addition, the foreign targeted obligation exception is available with respect to the excise tax applicable to issuers of registration-required obligations that are not in registered form.240 Thus, the exception from the one-percent excise tax will continue to apply to foreign targeted bearer bonds. According to the Sullivan and Cromwell Comments, this “effectively permits most non-U.S. issuers to issue foreign-targeted bearer bonds.”241 Thus, the excise tax applies with respect to any obligation that is not in registered form unless the obligation:

is issued by a natural person, matures in one year or less, is not of a type offered to the public, or is a “foreign targeted obligation.”

Repeal of treatment of portfolio interest. It should be noted that the new law repeals the treatment as portfolio interest of interest paid on bonds that are not issued in registered form but meet the foreign targeting requirements of Code Sec. 163(f)(2)(B).242 Under the provision, interest qualifies as portfolio interest only if it is paid on an obligation that is issued in registered form and either (i) the beneficial owner has provided

the withholding agent with a statement certifying that the beneficial owner is not a U.S. person (e.g., on an appropriate IRS Form W-8); or (ii) the Treasury has de-termined that such statement is not required in order to carry out the purposes of the provision.

It is anticipated that the Treasury may exercise its authority under this rule to waive the requirement of collecting Forms W-8 or other certification in circum-stances in which the Secretary has determined there is a low risk of tax evasion and there are adequate documentation standards within the country of tax residency of the beneficial owner of the obligations in question.243 Generally, however, as a result of the provision, interest paid to a foreign person on an obligation that is not issued in registered form is subject to U.S. withholding tax at a 30-percent rate, unless the withholding agent can establish that the beneficial owner of the amount is eligible for an exemption from withholding other than the portfolio interest exemption or for a reduced rate of withhold-ing under an income tax treaty.

Dematerialized book-entry systems treated as regis-tered form. The new law provides that a debt obligation held through a dematerialized book entry system or other book entry system specified by the Secretary will be treated, for purposes of Code Sec. 163(f), as held through a book entry system for the purpose of treating the obligation as in registered form.244 A debt obligation that is formally in bearer form is treated, for the purposes of Code Sec. 163(f), as held in a book-entry system as long as the debt obligation may be transferred only by book entries and the holder of the obligation does not have the ability to withdraw the obligation from the book-entry system and obtain a physical certificate in bearer form in the ordinary course of business.245 Thus, this provision codifies the existing administrative practice246 and will permit the Treasury to exempt bonds that are legally in bearer form from U.S. withholding tax if they are issued through the European and Japanese clearing systems.247

Repeal of exception to requirement that Treasury obligations be in registered form. The new law in-cludes a conforming change to Title 31 of the U.S. Code that repeals the foreign targeted exception to the definition of a registration-required obligation. Thus, a foreign targeted obligation of the Treasury must be in registered form.

Effective date. The provision applies to debt obliga-tions issued after March 18, 2012 (e.g., the date that is two years after the date of enactment). In contrast, under FATCA the bearer bond provision would have


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applied to any obligation issued more than 180 days after the date on which FATCA was enacted. Thus, obligations that are issued before the date of enactment will not be effected by the new provision. Similarly, obligations that are is issued by a natural person, which mature in one year or less, and are of a type not of a type offered to the public will not be impacted by this provision.

NYSBA Tax Section Comments. The New York State Bar Tax Comments on the foreign account tax compli-ance legislation which was part of the Extender’s Act raised two issues with respect to the foreign targeted obligation rules, one relating to the imposition of the excise tax and the other with respect to effective dates with the following discussion:248

Under current law, “foreign-targeted obligations” in bearer form (as determined for U.S. federal income tax purposes) that comply with certain requirements with respect to their offer and sale outside the U.S. are exempt from the TEFRA sanc-tions on bearer bonds, i.e., (i) denial of interest deductions to the issuer (ii) an excise tax on the issuer equal to 1 percent of the obligation’s prin-cipal amount multiplied by the number of years to maturity and (iii) denial to the foreign holders of such obligations the exemption from the 30 percent U.S. withholding tax on interest generally available for portfolio interest paid on U.S. issued debt. The [Extenders Act] would repeal this exemp-tion for “foreign-targeted obligations” in bearer form (excluding bonds if the rights to principal and interest payments under the bond are transferred through a dematerializied book entry system, in which case the bonds would be treated as regis-tered bonds under the [Extenders Act].249

In essence, this change in law would require U.S. issuers to issue bonds worldwide in registered form to avoid the imposition of a 30 percent withhold-ing tax on non-U.S. holders. The effect of requiring U.S. issuers to issue bonds in registered form for tax purposes is to require the beneficial owners of the bonds to certify as to their non-U.S. status (on IRS Form W-8-BEN) or otherwise comply with the rules designed to establish that status, unless, under proposes Code Sec. 871(h)(2)(B)(ii)(II), the Treasury Department affirmatively determines that such certification is not required. We believe that the revised legislation gives the necessary authority to the Treasury Department to exempt this certifica-

tion requirement where appropriate and applaud this grant of additional authority to the Treasury.

In addition, we appreciate that the revised legisla-tion has significantly restricted the applicability of the excise tax on bearer bonds so that bearer bonds issued by non-U.S. issuers are exempted from the excise tax, so long as (i) there are ar-rangements reasonably designed to ensure that the bonds will be sold or resold only to non-U.S. persons (ii) interest is payable only outside the U.S., and (iii) there is a legend on the face of the obligation to the effect that any U.S. person who holds the obligation will be subject to limitations under the U.S. income tax laws. However, we believe that the application of the excise tax is still over-broad, as the new rule would require foreign issuers issuing bearer debt to foreign investors to add a U.S. legend to the bearer obligations, even where there is no connection to the U.S. markets or U.S. investors as all. Under the current law, the legend is not required if the issuance satisfies the TEFRA C rules.250 Accordingly, we believe that the exemption from the excise tax should conform to existing rules. In addition, to the exemption from the excise tax obligations meeting the three requirements of the TEFRA D rules described above, we believe that obligations that conform to the TEFRA C rules should also be exempt, so that foreign issuers would be exempted from the ap-plication of the excise tax if they are issued outside the U.S., interest is payable only outside the U.S., and the issuer is not significantly engaged in U.S. commerce with respect to the issuance.

We appreciate that the revised legislation has amended the effective date so that the new rules will apply to obligations issued after two years from the date of the enactment of [the Extenders Act]. However, we would recommend that the Treasury Department be granted the authority to phase in the effective date of these provisions as it deems necessary or appropriate, particularly with respect to certain select markets where it may not be feasible to issue registered debt or collect taxpayer certifications. Significant time will be required in order for various foreign markets and clearing systems to develop mechanisms for handling Forms W-8 processing and for U.S. companies to adapt their capital raising plans to accommodate the repeal of the foreign-targeted

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bearer bond exemption. In addition, issuers will need considerable time to unwind and/or revise their debt programs to adapt to the new rules.

Foreign Trust ProvisionsUse of Foreign Trust PropertyUnder Code Sec. 643(i), a loan of cash or market-able securities made by a foreign trust to any U.S. grantor, U.S. beneficiary or any other U.S. person who is related to a U.S. grantor or U.S. beneficiary generally is treated as a distribution by the foreign trust to such grantor or beneficiary. This rule applies for purposes of determining if the foreign trust is a simple or complex trust or computing the distribution deduction for the trust or determining the amount of gross income of the beneficiaries, and computing any accumulation distribution. Loans to tax exempt entities are excluded from this rule.251 A trust treated under this rule as making a distribution is not treated as a simple trust for the year of the distribution.252

This rule does not apply for purposes of determining if a trust has a U.S. beneficiary under Code Sec. 679. A subsequent repayment, satisfaction, or cancella-tion of a loan treated as a distribution under Code Sec. 643(i) is disregarded for tax purposes.253 This Code Sec. applies a broad set of related party rules that treat a loan of cash or marketable securities to a spouse, sibling, ancestor, descendant of the grantor or beneficiary, other trusts in which the grantor or beneficiary has an interest, and corporations or part-nerships controlled by the beneficiary or grantor or by family members of the beneficiary or grantor, as a distribution to the related grantor or beneficiary.254

The new law expands Code Sec. 643(i) to provide that any use of trust property by the U.S. grantor or U.S. beneficiary (or any U.S. person related to such person) is treated as a distribution equal to the fair market value of the use of the property effective after March 18, 2010. Thus, the rent free use of real estate, yacht, art work or other personal property (wherever located including the United States) or an interest-free or below-market loan of cash or uncompensated use of marketable se-curities will trigger a distribution equal to the FMV for the use of such property to the extent of distributable net income or DNI. Presumably, the valuation of such use may be difficult to determine (e.g., the use value of art work) and may require independent third-party appraisals to substantiate this FMV to the IRS.

According to at least one commentator the provision was targeted at taxpayers who were using the offshore

trust vehicle to avoid U.S. taxation on their assets by putting their U.S. mansions, luxury yachts or art work into a foreign trust without imposing a charge on the beneficiaries for the use value or underlying cost of maintaining such assets (assuming this equates to the fair market value of the use of such property).

Exception. If the trust is paid the fair market value for the use of property or the market rate of in-terest on a loan by the trust, the new provision will not trigger a deemed distribution to the U.S. person. The new law does not apply to domestic trusts. Thus, individual may want to consider using domestic trusts (or domesticate existing foreign trusts) or paying the fair market value for the use of the trust property.

When does a foreign trust have a U.S. beneficiary? Under the grantor trust rules a U.S. person that directly or indirectly transfers property to a foreign trust255 is generally treated as the owner of the portion of the trust comprising the transferred property for any tax year in which there is a U.S. beneficiary of any portion of the trust.256 This treatment generally does not apply to transfers by reason of death or to transfers of property to the trust in exchange for at least the fair market value of the transferred property.257 A trust is treated as having a U.S. beneficiary for the tax year unless (i) under the terms of the trust, no part of the income or corpus of the trust may be paid or accumulated during the tax year to or for the benefit of a U.S. person; and (ii) if the trust were terminated at any time during the tax year, no part of the income or corpus of the trust could be paid to or for the benefit of a U.S. person.258

Regulations under Code Sec. 679 employ a broad approach in determining whether a foreign trust is treated as having a U.S. beneficiary. The determina-tion of whether the trust has a U.S. beneficiary is made for each tax year of the transferor. The default rule under the statute and regulations is that a trust has a U.S. beneficiary unless during the U.S. transf-eror’s tax year the trust meets the two requirements as stated above. Income or corpus may be paid or accumulated to or for the benefit of a U.S. person if, directly or indirectly, income may be distributed to or accumulated for the benefit of a U.S. person or corpus of the trust may be distributed to or held for the future benefit of a U.S. person.259

The determination is made without regard to whether income or corpus is actually distributed, and without regard to whether a U.S. person’s interest in the trust in-


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come or corpus is contingent on a future event. A person who is not a named beneficiary and is not a member of a class of beneficiaries will not be taken into account if the transferor can show that the person’s contingent interest in the trust is so remote as to be negligible.260

In considering whether a foreign trust has a U.S. beneficiary under the terms of the trust, the trust in-strument must be read together with other relevant factors including (i) all written and oral agreements and understandings related to the trust, (ii) memoranda or letters of wishes, (iii) all records that relate to the actual distribution of income and corpus, and (iv) all other documents that relate to the trust, whether or not of any purported legal effect.261 Other factors taken into ac-count in determining whether a foreign trust is deemed to have a U.S. beneficiary include whether the terms of the trust allow the trust to be amended to benefit a U.S. person, the trust instrument does not allow such an amendment, but the law applicable to the foreign trust may require payments or accumulations of income or corpus to a U.S. person or the parties to the trust ignore the terms of the trust, or it reasonably expected that they will do so to benefit a U.S. person.262

If a foreign trust that was not treated as a grantor trust acquires a U.S. beneficiary and is treated as a grantor trust under Code Sec. 679 for the tax year, the transferor is taxable on the undistributed net income263 computed at the end of the preceding tax year.264 Any additional amount included in the transferor’s gross income as a result of this provision is subject to the interest charge rules of Code Sec. 668.265

Under the grantor trust rules, a U.S. person a U.S. person that directly or indirectly transfers property to a foreign trust will generally treated as the owner of the trust for tax purposes, unless (i) under the terms of the trust, no part of the income or corpus of the trust may be paid or accumulated for the benefit of the U.S. person, and (ii) were the trust terminated, no income or corpus could be paid to the U.S. person. In determining whether a person is a U.S. beneficiary of a foreign trust, the IRS will consider any agreement or understanding whether written, oral or otherwise. The new law “clarifies” the rules for determining when a foreign trust has a U.S. beneficiary. For this purpose, a foreign trust will have a U.S. beneficiary even if:

the U.S. person’s interest in the trust is contingent on a future event (e.g., a contingent or future beneficiary); andthe U.S. person has discretionary authority under a trust agreement, power or other document) to make a distribution to or for the benefit of a U.S. beneficia-

ry unless (i) the terms of the trust specifically identify the class of persons receiving such distributions, and (ii) none of those persons are U.S. persons.

Presumption: A Foreign Trust Has a U.S. BeneficiaryUnder the grantor trust rules, a U.S. person that directly or indirectly transfers property to a foreign trust266 is generally treated as the owner of the portion of the trust comprising that property for any tax year in which there is a U.S. beneficiary of any portion of the trust.267 This treatment generally does not ap-ply to transfers by reason of death, or to transfers of property to the trust in exchange for at least the fair market value of the transferred property.268

A trust is treated as having a U.S. beneficiary for the tax year unless, (i) under the terms of the trust, no part of the income or corpus of the trust may be paid or accumulated during the tax year to or for the benefit of a U.S. person, and (ii) were the trust terminated at any time during the tax year, no part of the income or corpus of the trust could be paid to or for the benefit of a U.S. person.269

Code Sec. 6048 imposes various reporting obliga-tions on foreign trusts and persons creating, making transfers to, or receiving distributions from such trusts. Within 90 days after U.S. person transfers property to a foreign trust the transferor must provide written notice of the transfer to the Secretary. 270

The new law creates a rebuttable presumption ef-fective after March 18, 2010, if a U.S. person directly or indirectly transfers property to a foreign trust, the Treasury may treat the trust as having a U.S. ben-eficiary. However, the U.S. person can avoid such characterization by submitting information (as the Treasury may require) and demonstrate to the satisfac-tion of the IRS that (i) under the terms of the trust no part of the income or corpus of the trust may be paid or accumulated during the tax year to or for the benefit of a U.S. person, and (ii) if the trust were terminated during the tax year, no part of the income or corpus could be paid to or for the benefit of a U.S. person

Reporting Requirements of U.S. Owners of Foreign TrustsCode Sec. 6048 imposes various reporting obligations on foreign trusts and persons creating, making trans-fers to or receiving distributions from such trusts. If a U.S. person is treated as the owner of any portion of a foreign trust under the grantor trust rules, the U.S. person is responsible for ensuring that the trust files an

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information return for the year and that the trust pro-vides other information as the Secretary may require to each U.S. person who (i) is treated as the owner of any portion of the trust, or (ii) receives (directly or indirectly) any distribution from the trust.271

In other words, if a U.S. person is treated as the owner of a foreign trust under the grantor trust provi-sions, the U.S. person is responsible for ensuring that the trust files an information return for the year and that the trust provides other information to the IRS as the Treasury may require to each U.S. person who is treated as the owner of any portion of the trust or receives any distribution from the trust.

The new law requires a U.S. person that is treated as the owner of a foreign grantor trust to provide information to the Treasury as it may require with respect to the trust, in addition to ensuring that the trust complies with its reporting obligations effective after March 18, 2010.

Penalty for Failure to Satisfy Reporting Obligation for Foreign TrustsCode Sec. 6048 imposes various reporting obliga-tions on foreign trusts and persons creating, making transfers to, or receiving distributions from, such trusts. Generally, a trust is a foreign trust unless a U.S. court is able to exercise primary supervision over the trust’s administration and a U.S. trustee has authority to control all substantial decisions of the trust.272

If a U.S. person creates or transfers property to a foreign trust, the U.S. person generally must report this event and certain other information by the due date for the U.S. person’s tax return, including extensions, for the tax year in which the creation of the trust or the transfer occurs.273 Similar rules apply in the case of the death of a U.S. citizen or resident if the decedent was treated as the owner of any portion of a foreign trust under the grantor trust rules or if any portion of a for-eign trust was included in the decedent’s gross estate.

If a U.S. person directly or indirectly receives a dis-tribution from a foreign trust, the U.S. person generally must report the distribution by the due date for the U.S. person’s tax return, including extensions, for the tax year during which the distribution is received.274 If a U.S. person is the owner of any portion of a foreign grantor trust at any time during the year, the person is responsible for causing an information return to be filed for the trust, which must, among other things, give the name of a U.S. agent for the trust.275

If a notice or return required under the rules just described is not filed when due or is filed without

all required information, the person required to file is generally subject to a penalty based on the “gross reportable amount.”276 The gross reportable amount is (i) the value of the property transferred to the for-eign trust if the delinquency is failure to file notice of the creation of or a transfer to a foreign trust, (ii) the value (on the last day of the year) of the portion of a grantor trust owned by a U.S. person who fails to cause an annual return to be filed for the trust, and (iii) the amount distributed to a distributee who fails to report distributions.277

The initial penalty is 35 percent of the gross report-able amount in cases (i) and (iii), and five percent in case (ii).278 If the return is more than 90 days late, additional penalties are imposed of $10,000 for every 30 days the delinquency continues, except that the aggregate of the penalties may not exceed the gross reportable amount.279

In no event may the penalties imposed with respect to any failure to report under Code Sec. 6048 exceed the gross reportable amount.280

If these reporting obligations are not met, the new law increases the minimum and maximum penalties with respect to the failure to report on certain foreign trusts. Under the new law, an initial minimum penalty of $10,000 or 35 percent of the gross reportable amount may be imposed for failing to report where the Treasury has insufficient information to determine the gross re-portable amount of the property transferred to a foreign trust under Code Sec. 6048. The additional penalty for every additional 30 days of delinquency will continue to apply. The maximum penalty for failure to report may exceed the gross reportable amount. However, to the extent the taxpayer provides sufficient information for the Treasury to determine that the aggregate amount of the penalties exceeds this amount, the IRS is required to refund such excess to the taxpayer. A requirement that a U.S. person ensures that a foreign trustee or other fiduciary complies with U.S. reporting requirements for a foreign trust may be unworkable. This provision is effective to notices and returns required to be filed after December 31, 2009.

U.S. Withholding Tax and Information Reporting ExaminationsIntroductionOn July 29, 2008, the IRS published inTernal revenue Manual (IRM) 4.10.21 entitled, “U.S. Withholding


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Agent Examinations—Form 1042,” which provides guidance to IRS agents on how to audit U.S. with-holding agents reporting of U.S. income payments to U.S. persons. It remains to be seen if and when the IRS will update the IRM to address U.S. withholding audits for the new law. However, the existing guid-ance by the IRS for FDAP audits should be helpful in addressing the resource needs and processes which will be necessary to remain compliant with the new law and avoid excess exposure.

IRM 4.10.21 covers two types of U.S. withholding agent audits. The first part of provides general guidance for audits of U.S. financial institutions, which may have nonresident alien (NRA) withholding tax and report-ing requirements in connection with their custodial or brokerage activities. The second part provides general guidance for audits of U.S. nonfinancial entities that may have NRA withholding and reporting respon-sibilities with respect to their payments to foreign persons for obtaining services or other entitlements. The IRM does not discuss the qualified intermediary or QI external audits required under the QI Agreement between the QI and the IRS. It was recommended that the examiner should also view, as an additional refer-ence, the Industry Directive on Examinations of Forms 1042, dated October 31, 2003, for certain guidance with regard to U.S. withholding agent audits.281

Form 1099 Backup Withholding Tax vs. NRA With-hholding Tax. The Form 1099 backup withholding and NRA Withholding Tax regimes share some basic similarities. Both systems require the reporting of cer-tain types of income and the withholding of taxes in certain cases. Both have an annual income tax return requirement, which is Form 945282 with respect to backup withholding and Form 1042283 with respect to reporting certain U.S. source payments made to foreign persons and amounts withheld. In addition, both have informational reporting requirements with respect to income recipients (Forms 1099 and Forms 1042-S284 for U.S. and foreign recipients, respectively). Apart from these separate reporting requirements, withhold-ing and reporting occurs under these regimes based on different criteria. As a result, despite some general similarities, a major determination for a withholding agent is in properly documenting or otherwise clas-sifying a recipient as either a U.S. or a foreign person. When a recipient is a U.S. person, NRA withholding is inapplicable, and Form 1099 reporting and backup withholding is sometimes required. When a recipient is foreign person, NRA withholding and reporting is required with respect to certain income payments and

no Form 1099 or backup withholding requirements are triggered.285

Although this IRM section deals principally with NRA Withholding, Form 1099 reporting and backup withholding also needs to be considered as part of an integrated audit. Auditing Form 1042 information can result in collateral adjustments to Forms 1099 and 945 when, for example, persons classified as foreign by a withholding agent need to be reclassified as U.S. persons subject to backup withholding and Form 1099 reporting. Additionally, deficiencies in a withholding agent’s Form 1042 related systems may indicate a generic problem in its tax reporting systems.286

Important items to consider for pre-audit planning. An audit of Form 1042 may result in an adjustment to both Form 1042 and Form 945.287 Therefore, when au-diting Form 1042, the examiner must always determine the statute of limitations on the audit years for both Form 1042 and Form 945. If applicable, the examiner is required to obtain and have executed Form 872 and Form SS-10 to protect the statute of Form 1042 and Form 945, respectively.288 It is highly recommended that the examiner determine whether the taxpayer has entered into any agreements with the IRS in regard to their withholding systems, policies, procedures or other requirements, such as (i) submissions under the Rev. Proc. 2004-59289 voluntary compliance program (“the Code Sec. 1441 VCP” ), including any applicable remediation agreement; (ii) closing agreement; (iii) pre-filing agreement for the audit year; or (iv) memorandum of understanding (including one covering an on-line Form W-8 system). If so, the examiner should obtain a copy of the memorandum, agreement or submission for background and to ensure that the taxpayer has satisfied any of its conditions applicable to the audit year.290

U.S. financial institution withholding tax audit. Commercial banks and brokerage firms are examples of financial institutions that act as U.S. withholding agents. Certain of these institutions act as intermediaries with respect to their clients’ investments in securities and deposits. As a result, these institutions may make investments and receive payments in a fiduciary or custodial relationship with their clients. For example, when a foreign person’s account is credited by a broker-dealer with U.S. source FDAP income that the broker-dealer has received on the foreign person’s be-half, the financial institution may have NRA reporting and withholding responsibilities with respect to the income. This type of audit will focus on determining if such amounts paid to account holders have been properly subjected to NRA withholding and reporting,

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including whether any payments treated as paid to for-eign persons should have been instead been subjected to backup withholding under Code Sec. 3406.291

Functional review of NRA operational procedures & written procedure and training manuals. The examiner should perform a functional review of the U.S. with-holding agent’s NRA withholding tax related operating procedures.292 The first step is a review of written proce-dure and training manuals such as the following:

Summaries of withholding tax systemsSystem flow charts covering payments made to account holdersInternal control, audit reports or other information which relate to the withholding tax functionManuals related to functions that may have withholding tax implications, including the fol-lowing:

Payment system designAccount opening proceduresValidation procedures for Form W-8Procedures for determining or classifying undocumented accounts

Application of presumption rulesTraining manuals for personnel for departments that control the following functions:

NRA Withholding tax determinations or implementationOpening new accountsPreparing Forms 1042 & 1042-S

Evaluation of the above written procedures (or lack thereof) may provide the examiner with an indicator of the overall reliability of the taxpayer’s withholding tax functions. This assessment may assist in determin-ing the extent of additional audit procedures, such as the review of account files statements and with-holding certificates.293

Review of Forms 1042 and 1042-S—Form 1042. Reconciliation—The gross income and net tax liability reported on Form 1042 should agree to the gross income and taxes withheld as determined by com-bining these amounts from all Forms 1042-S filed. To verify this, the examiner should obtain the taxpayer’s reconciliation workpapers and Forms 1042-S. The examiner can also request for a computer audit spe-cialist (CAS) to perform reconciliation in certain cases of payments contained in computer sensitive files. The examiner should account for line 66 of Form 1042, credit for amounts withheld by other withholding agents, during the reconciliation process.

Deposit Requirements—The tax liability for each ap-plicable period of the year (normally quarter-monthly,

which is the seventh, 15th, 22nd and last day of the month) is required to be shown in the Record of Fed-eral Tax Liability section on Form 1042. The examiner should ensure that the withholding agent did not in-stead complete this section, in some situations, based on deposit dates, as this error may prevent identifica-tion of late deposits. The examiner should otherwise insure that deposits were made timely by reviewing the taxpayer’s payments and deposits records. Due dates for deposits and associated penalties follow:

If the total withholding tax for a calendar year is less than $200, the tax can be paid when the tax return (Form 1042) is timely filed. If at the end of any calendar month the total amount of withholding tax is more than $200 but less than $2,000, the withholding agent must deposit the taxes within 15 days after the end of the month. If at the end of any quarter-month period the with-holding tax is $2,000 or more, the withholding agent must deposit taxes within three banking days after the end of the quarter-monthly period. A quarter-monthly period ends on the seventh, 15th, 22nd, and last day of the month.294

Form 1042-S. With the assistance of the CAS, year-end account statements (or the information included on them) should be obtained on a sample basis. The Forms 1042-S for these accounts should be compared to verify the correctness of such items as (i) gross income (box 2), (ii) tax withheld (box 7), (iii) income code (box 1), (iv) tax rate (box 5), (v) exempt code (box 6), and (vi) recipient code (box 12).295

Account opening and updating procedures. Nor-mally the status of an account holder, the withholding rates and other information are entered into the withholding agent’s systems. Generally, this can be expected to occur when an account is opened. These procedures are critical in determining (i) the status of the account holder as a foreign or U.S. person; (ii) the type of account holder (i.e., as an individual or entity); (iii) for foreign persons, the basis of any treaty claims; and (iv) ultimately the withholding rate, if any.296

New account examination procedures. The exam-iner should review the procedures for new accounts using the following criteria: any information, other than withholding certificates (i.e., Forms W-9 and W-8), used to determine if the account is held by a U.S. person or a foreign person, such as (i) residence and mailing addresses shown on account opening applications; (ii) documentation submitted by the ac-count holder for identification purposes (i.e. passports,


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driver’s license, articles of incorporation, etc.); and (iii) account-file information or correspondence. 297

Procedures should be used to determine an account holder’s status for withholding purposes, including when the account is not documented with a withhold-ing certificate or when information provided during account opening is inconsistent with the information showing on the certificate. The examiner should fur-ther determine if the information noted above is used for withholding purposes in lieu of the presumption rules for undocumented account holders.298

The information noted in above cannot be used in lieu of presumption rules for undocumented ac-count holders. The U.S. withholding agent can rely on a valid withholding certificate (i.e., Form W-8), documentary evidence only in the case of off-shore accounts, or the regulations’ presumption rules to determine the status of a payee. This information is relevant, however, because if for a specific account holder the information contradicts claims on a with-holding certificate or documentary evidence, such documents may be unreliable or invalid based on the applicable standard of knowledge imputed to the withholding agent.299 See “Requirement to rely on presumption rules” and “Validation process.”

Review procedures for separation of functions. For example, an individual who solicits Forms W-8 should be different from the individual who validates the Forms. In addition, the individual that validates should be from a different department than the individual who solicits the form. In addition, the procedures for recording and updating information into the withholding and account systems (i.e., master files) to reflect information received via Forms W-8 and opening procedures should be reviewed. The following minimum information should be captured by the NRA Withholding and accounting systems from Form W-8: (i) foreign person status, (ii) type of Form W-8 (BEN, EXP, IMY, or ECI) used to document the account holder, (iii) type of entity (corporation, trust, etc.), (iv) treaty claim (Part II of Form W-8BEN) and limitations or conditions set forth on this form, and (v) expiration date of Form W-8 (if applicable).300

Due diligence—Standard of knowledge. The ex-aminer should insure that the withholding agent has applied the due diligence standards set forth in Reg. §1.1441-7(b)(1) in its determination of the correct reporting and withholding to be applied. Under this regulation, if a withholding agent knows or has reason to know that a withholding certificate (e.g., Form W-8BEN) or documentary evidence provided by the payee is unreliable or incorrect, the withhold-

ing agent must withhold and report at a full rate of 30 percent. If a withholding agent relies on another agent to obtain documentation, the withholding agent is generally considered to know, or have reason to know, facts within the knowledge of its agent. The account file information is relevant information for an examiner to make any such determinations.301

Reason to know. Generally, a withholding agent will be considered to have known a claim of foreign status or for a treaty-based withholding rate to be incorrect or unreliable if the statements contained in the withholding certificate or in other informa-tion which the withholding agent has, would cause a reasonable person to question the claims made. A more specific reason to know standard applies with respect to payments by financial institutions.302

Actual knowledge. Despite representations made on an otherwise valid withholding certificate, a with-holding agent must withhold and report based on its actual knowledge of facts concerning the recipi-ent when that knowledge results in a higher rate of withholding than would have been applied by sole reliance on the certificate. For example, if a with-holding agent makes a payment to a U.S. person and the withholding agent has actual knowledge that the U.S. person is acting as an agent for a foreign person, the withholding agent must treat the payment was made to a foreign payee. (This does not apply when the U.S. person is a financial institution.)303

Application of presumption rules. If a withholding agent cannot reliably associate a payment with a valid withholding certificate (or documentary evidence for offshore accounts), the withholding agent must follow the presumption rules contained in Reg. §1.1441-1(b)(3) to determine the status of the payee for withholding and reporting purposes, subject to the above knowl-edge standards. If the withholding agent fails to comply with the presumption rules, it may be liable for the correct withholding tax, interest and penalties.304

Classification of entity. The withholding agent must generally presume that a payee is an individual, a trust, an estate, a corporation or one of the persons enumer-ated under Reg. §1.6049-4(c)(1)(ii)(A)(i) through Reg. §1.6049-4(c)(1)(ii)(Q), or a partnership by following the rules under Reg. §1.1441-1(b)(3).305

U.S. vs. foreign status. Generally, a payment that a withholding agent cannot reliably associate with valid documentation is presumed made to a U.S. per-son.306 However, the payee will be presumed to be a foreign person if the payee is an exempt recipient and there are certain indicia of foreign status.307 Indicia

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of foreign status is also relevant for determining the status of a partnership as U.S. or foreign.308

Foreign vs. U.S. status of partnership. If it is pre-sumed or know that a payee is a partnership, the withholding agent must determine the classification of the partnership as foreign or domestic. A partner-ship is presumed to be foreign when its EIN begins with “98,” where the payer’s communications with the partnership are mailed to an address in a foreign country, or where the payment is made outside the United States. In all other circumstances, the payer may presume that the partnership is domestic (in which event no NRA withholding tax is applicable, however, backup withholding may be triggered).309

Requirement to rely on presumption rules. A with-holding agent that withholds at a rate less than that applicable under the presumption rules or based on its actual knowledge will be liable for the tax required to be withheld (or backup withheld) without the ben-efit of a reduced rate, unless the withholding agent is able to demonstrate that the proper amount of tax was paid.310 Even if the withholding agent establishes that the proper amount of tax was paid by the recipient, the withholding agent may be subject to penalties.311 However, a withholding agent may not rely on a payee’s presumed status if it has actual knowledge or reason to know that the status or characteristics of the payee or beneficial owner differ from its presumed status and a greater amount of withholding tax would apply based on such knowledge.312

Validation. This section provides general guidance for the review of Forms W-8. It also provides guidance to determine the corrected withholding tax and/or reporting requirements if the forms are found to be invalid or un-reliable. A U.S. withholding agent may generally rely on a properly completed withholding certificate (i.e., Forms W-8), as defined in Reg. §1.1441-1(c)(16) to establish a recipient’s foreign status or a claim of treaty benefit. Documentary evidence can instead be used with respect to offshore accounts. The withholding certificate must be completed with respect to any item on the form that is relevant to the claim made by the direct account holder and must not contain claims which are inconsistent with claims made in any part of the form. The certificate might also be invalid if it contradicts or is inconsistent with other information known to the withholding agent. In this connection, a withholding agent must rely on its actual knowledge or the reason to know standard in the regulations when such knowledge results in a higher withholding tax rate than would have occurred through reliance on the withholding certificate.313

Account review. The following should generally be requested for each account reviewed: (i) withholding certificates or documentary evidence (for offshore ac-counts); (ii) account file information for information needed to administer and open the account such as, mailing instructions and addresses, information sup-porting the account holder’s status as an individual, corporation, or other entity; (iii) authorization for certain transactions (i.e., buy or sell stock); and (iv) other account instructions and correspondence ac-count application forms and updates.314

Validation process. The U.S. withholding agent can generally rely on a valid Form W-8 to determine the correct taxes to be withheld and the correct reporting of income. If the withholding agent does not have a valid Form W-8, the withholding agent must generally use the applicable presumption rules to determine the attributes of the account holder relevant for pre-scribing the rate of withholding. If the withholding agent does not rely on the presumption rules when required to do so, the withholding agent may be li-able for taxes under withheld as well as interest and penalties. It is recommended that the validation of Form W-8 be performed in three steps: 1. Line by line review to ensure that the form is

complete and consistent on its face. Note that a failure on any one line item does not necessarily invalidate the certificate and all claims made therein. However, the examiner should consider such failures carefully and shall take special caution in the case of systemic failures.

2. Comparison of information on the Form W-8 with the information in the account file and/or account application form. A material con-tradiction may invalidate the Form W-8. In this connection, the examiner should review account file information and new account application forms and updates for indication of U.S. status (i.e., U.S. mailing address, or a copy of a U.S. driver’s license used as identification to open the account) or information that would indicate residence in country other than that claimed on the Form W-8 for an account holder making a treaty based claim.

3. Check of expiration of Form W-8 to ensure valid with respect to the applicable payment. It should also be noted that, in general, an invalid W-8 cannot be perfected by other supporting documentation, except for curing address. The examiner should exercise sound judgment in applying these guidelines.315


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Permanent and mailing address considerations. The examiner should pay special attention to the address lines on the withholding certificates and the addresses otherwise reported by the account holder or shown in the account files and customer master files.316

A person’s permanent residence address is an address in the country where the person claims to be a resident for purposes of that country’s income tax. In the case of a certificate furnished in order to claim a reduced rate of withholding under an income tax treaty, the residence must be determined in the manner prescribed under the applicable treaty.317 The permanent address on Form W-8 cannot be a U.S. address. For NRA withholding purposes, the permanent address cannot be a financial institution (unless that financial institution is the ben-eficial owner), in care of address, or any other similar type which does not indicate a physical location.318 The examiner should check addresses indicated on records such as the customer master files, which may include changes in circumstance (i.e., new U.S. addresses or addresses outside treaty country) that have not been considered by the withholding agent for updating its certification forms.

The withholding agent has reason to know that a Form W-8 is unreliable or incorrect to establish a direct account holder’s status as a foreign person if a U.S. mailing address is listed on this line, subject to the below cure provision.319

The U.S. withholding agent can rely on a Form W-8 with a defective address line to establish foreign status or treaty claims if it has obtained additional docu-mentation from the account holder as prescribed in Reg. §1.1441-7(b)(5)(i). Examples of such additional documentation would be: for individuals, a govern-ment issued document with documentary evidence such as a non-U.S. photo ID (e.g., passport, driver license). The document must be valid when submit-ted to the withholding agent and must be submitted to the withholding agent within three years of the date of the payment; and reasonable written explanation from the account holder supporting foreign status must be included. For entities, documentation that proves entity status or, for an account maintained outside the United States, a tax information statement filed with a country with which the United States has an income tax treaty in effect, should be included. These examples show the documentation that can be accepted:320

Entity documentationCorporation: Articles of incorporationPartnership: Partnership agreementTrust: Trust agreement

Form W-8 provided after the date of payment. The examiner may consider, among other factors, the following in determining whether a withhold-ing certificate received after the date of payment (or other documentation or evidence if it is an offshore account) should be accepted for purposes of allowing a reduced withholding rate with respect to payments to foreign persons:

Whether information and representations on a later secured withholding certificate (or on other documentation if it is an offshore account) provided are consistent with information in the account file or in other records maintained by the withholding agent, the examiner should request and review all account files as a resultWhether the withholding certificate (or other documentation if it is an offshore account) estab-lishes facts in existence at the time the relevant payments were made

Example. The Form W-8 was signed June of 2006 to support foreign status and treaty benefits for a payment received in January of 2005. The exam-iner should ask the taxpayer how they confirmed that residency of the beneficial owner was the same in January 2005.

In general, the examining agent should consider all the underlying facts and circumstances when validating a Form W-8 provided after the date of payment, and should accept any such documentation only when en-tirely satisfied with its reliability and veracity. If the proof consists of showing that the tax was paid by the account holder, the withholding agent may still be subjected to interest and penalties under Code Sec. 1463.321

Use of statistical sampling. Validating Forms W-8 will normally require statistical sampling of accounts because of the number of accounts and volume of payments made. A referral for CAS assistance should normally be submitted early in the audit process. The starting point for sampling of a financial institution’s NRA payments should be, as noted above, a thorough analysis of the withholding agent’s systems to ensure, among other things, that all applicable payments and payees are incorporated into the withholding and reporting system. Potential sampling units to consider in developing a sampling plan include total payments made to an account holder, total payments made to an account, reportable amounts per Forms 1042-S issued by the withholding agent and individual payments. Regardless of the sampling unit chosen,

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withholding certificates and account file information should be reviewed for every account holder receiv-ing a payment selected for review. In order to reduce audit time, the CAS may request that the withholding agent review the sampling plan to provide input to improve its efficiency or raise other issues.

Input may include, but is not limited to, determining the sampling unit, sample size and stratum criteria, along with appropriate statistical and auditing justifications. The use of statistical sampling as an audit tool by the IRS does not require the approval of the taxpayer.322

Stratification by factors other than just reportable amounts should be considered, including (i) lines of business, (ii) type of W-8 (BEN, EXP, ECI or IMY), (iii) type of income (dividends, interest, other), (iv) type of recipient per Form 1042-S recipient code, (v) withholding tax rates, (vi) type of transaction, and (vii) recipient’s country of residence for tax purposes per Form 1042-S.323

Withholding and reporting verification. In de-termining the correct rate of NRA withholding and backup withholding for a single payment or group of similar payments, account documentation, ap-plicable presumption rules, type of payment being made, and any applicable tax treaties should first be taken into account. Once the correct rate of tax is determined based on these factors, steps should be taken to ensure the correct rate was applied for withholding purposes, and that amounts withheld were accurately reported via Forms 1042-S or Forms 1099, as applicable. In instances where additional NRA withholding, additional backup withholding, or assessment of penalties results from the use of a statistical sample, the results should be extrapolated to the sample population where appropriate.

To this end, account statements and similar records that show the type of income earned and tax withhold-ing should be obtained for each applicable payment and the associated payees. Account records that show how the withholding agent has classified payments along with records that show how those same pay-ments were classified by the payee of the income to the withholding agent may also be requested.

Copies of all Forms 1042-S and Forms 1099 filed by the withholding agent to report all payments under review should be obtained to ensure proper reporting, including cases in which the examiner is not proposing any change to the withholding rate. All information appearing on Forms 1042-S that might affect withholding tax (e.g., income codes and amounts, exemption codes, recipient code, recipient

country for tax purposes, amounts repaid to account holders, etc.) should also be reviewed for accuracy and completeness, and should be compared to the documentation reviewed by the examiner.324

Transactions and other items requiring special treatment by withholding agents. NRA withholding and reporting for the transactions listed below require application of special rules. In order for the with-holding agent to comply with these requirements, the withholding agent should establish procedures to identify and to ensure the correct withholding and reporting for each type of transaction. After identi-fying their existence, the examiner should ask the taxpayer for a detailed explanation of the withholding and reporting procedures for each of these types of transactions. If the procedures are deficient or incom-plete, the examiner should expand the examination to ensure that the transactions were properly reported and that taxes were properly withheld.325

Real estate investment trust distributions. REIT distributions to foreign shareholders are subject to NRA withholding, except when the distribution is designated as a capital gain dividend, a return of basis, or a distribution in excess of the shareholder’s basis in the REIT stock.326 For capital gain dividends, a 35-percent withholding tax applies under Code Sec. 1445.327 As enacted under the American Jobs Creation Act of 2004, however, capital gain distributions are not taxed under Code Sec. 1445 for foreign share-holders owning REIT stock regularly traded on a U.S. exchange that have not held over five percent of such class of the REIT’s stock at any time during the year of the distribution. Such distributions are instead subject to NRA withholding. The examiner should question how the withholding agent determines the correct rate and should spot check several REIT distributions.328

Original issue discount (OID). Generally, no NRA Withholding applies to the sale of debt obligations, even though accrued interest or OID is included in the amount paid by the purchaser to a foreign seller. The major exception is for sales where the principal purpose is to avoid tax and the withholding agent has actual knowledge or has reasons to know of such purpose. The sale is not reportable on a Form 1042-S unless NRA withholding was required under this principal purpose test. Redemptions of obligations that carry OID are subject to NRA withholding tax. The amount subject to withholding tax is the amount accrued to the holder from the date of purchase, as determined by the withholding agent. If the withhold-ing agent has not been provided with reliable date of


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purchase information or cannot otherwise calculate the amount of OID to the holder, then the withhold-ing agent must withhold on the entire amount of OID accrued since the obligation’s issuance. In determin-ing the taxable amount of OID, a withholding agent may rely on information provided in IRS Publication 1212, List of Original Issue Discount Instruments. The amount of taxable OID (or treated as taxable) is re-portable on Form 1042-S. Short-term OID obligations (i.e., with a maturity of 183 days or less from the date of original issue) are not subject to NRA withholding tax or reporting on Form 1042-S.329

Securities lending. When a loan of securities is outstanding during the record date for a dividend or interest payment, the lender of the securities is, among other things, typically entitled to a payment from the borrower to account for the foregone divi-dend or interest (i.e., since the lender is not the holder of record on the record date). The payment made by the borrower of securities is called a “substitute divi-dend” or “substitute interest,” which may be subject to NRA withholding tax if paid to foreign persons.

For NRA withholding purposes, a “look-through” rule applies to define the character and source of the substitute amount paid in connection with the loan of any securities. Based on the “look-through” rule, a substitute interest amount is treated as portfolio interest if the underlying security generates portfolio interest in connection with the payment. These rules further apply to security lending transactions between foreign counterparties, subject to provisions to mitigate over withholding that could result from repeated lending of the same underlying security.330

Transactions and other items requiring special treatment by withholding agents—One-night depos-its (sweep accounts). Commercial banks sometimes offer their larger accounts preferred treatment. One of these benefits is earning interest on the balance at the close of the business day. Typically the balances are combined and used to purchase interest bearing securities. The next business day the interest earned is credited to the customers account.331

Repurchase agreements (REPOs). Under U.S. tax principles, a REPO is typically characterized as a collateralized loan where the purchaser of the un-derlying security is deemed to be a lender of funds to the seller in the amount of the purchase price. The seller of the security is treated as the borrower. The loan is for the period until the REPO matures, when the securities are sold back to the original seller (i.e., the cash borrower). Typically, the repurchase price

exceeds the original sales price, giving rise to a charge consisting of financing interest.

If the financing interest is U.S. sourced and paid to a foreign person, it may be subject to NRA with-holding. However, see the exception for certain short term obligations referenced in Reg. §1.1441-2(a). In addition, an examiner may find substitute payments (dividend or interest) made by the cash lender to the borrower as part of the REPO. These substitute pay-ments are similar to those typically seen in securities lending transactions, whose sourcing is determined with respect to the underlying security for withhold-ing and reporting purposes.332

Syndicated loans. A syndicated loan results when financial institutions collectively participate in fund-ing a single loan. Generally, one of the participants will act as an administrator and distribute the interest income to the other participants. The administrator will be the withholding agent. The following issues should be considered related to syndicated loans:

Bank loan exception. Code Secs. 871(h) and 881(c) generally provide that a non-U.S. person is exempt from the 30-percent withholding tax on portfolio interest. There are several limitations on this exemption such as the “bank loan excep-tion.” The portfolio exemption does not apply to any interest received by a bank on the extension of credit made pursuant to a loan agreement entered into in the ordinary course of its trade or business.333 Accordingly, foreign banks, which are participants in the syndicated loan, should not benefit from the portfolio exemption. Change in circumstances events. Often the participants will change. For example, when the original participants sell all or a portion of their interests in the loan to another bank, withholding related documentation is required from each of the new participants. An audit concern is to de-termine if required Forms 1042 and 1042-S were not filed and/or Forms W-8 were not secured.334

Payments to foreign intermediaries and foreign flow-through entities. Reportable amounts that with-holding agents pay to foreign intermediaries or foreign flow-through entities require specific treatment because intermediaries and flow-through entities are not ben-eficial owners of income. Examples of flow-through entities are foreign partnerships, simple and grantor trusts, and disregarded entities. Foreign intermediaries and flow-through entities must provide the U.S. with-holding agent a Form W-8IMY. This form indicates that the account holder is not the beneficial owner of the

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reportable income. The form also indicates whether the account holder has entered into an agreement with the IRS to act as a withholding agent. Foreign financial institutions can enter into an agreement with the IRS to act as a qualified intermediary (QI). All foreign interme-diaries that do not have an agreement with the IRS to act as QIs are, by default, nonqualified intermediaries (NQIs).335 Foreign partnerships and simple or grantor trusts can elect to enter into an agreement with the IRS become a withholding partnership (WP) or a withhold-ing trust (WT). A foreign flow-through entity that has not become a withholding partnership or a withhold-ing trust is, by default, a nonwithholding partnership (NWP) or a nonwithholding trust (NWT).336

Withholding and reporting on payments to qualified intermediary. The QI can elect whether or not to assume primary withholding responsibilities. The U.S. withhold-ing agent will be notified about this decision with a valid Form W-8IMY that the QI furnishes to the withholding agent. If the QI has assumed primary withholding re-sponsibilities, the U.S. withholding agent is not required to withhold NRA taxes with respect to those payments associated with QI-designated accounts. However, it is still subject to reporting on these payments. The U.S. withholding agent will report payment amounts paid to the QI with respect to such accounts on Form 1042-S with zero-percent taxes withheld. These Form(s) 1042-S will be issued to the QI by the U.S. withholding agent.

If the QI has not assumed primary withholding respon-sibilities, the withholding agent will withhold based on withholding statements provided by the QI with respect to QI-designated accounts. The QI is not required to provide specific client names and client details to the withholding agent. Instead the QI will provide Form(s) 1042-S that indicate the total dollar amount and amounts withheld on a “pooled basis,” i.e., amounts subject to withholding at the 15-percent withholding rate would be one pool, amounts subject to withholding at the 30-per-cent withholding rate would be another pool, etc. There will be a separate Form 1042-S for each pool. Assuming the QI assumed primary withholding responsibility, the Forms 1042-S will show taxes withheld. 337

Under the QI contract with the IRS, the QI is re-quired to designate the accounts that are covered under the QI contract. For accounts that the QI did not designate as covered by the QI contract, or for in-direct account holders of the QI the below described NQI procedures shall be followed.

Withholding and payments to NQIs. An NQI should provide to the withholding agent a Form W8-IMY and the appropriate documentation for each of

the beneficial owners that are to receive the income paid by the withholding agent to the NQI. The NQI must also provide a withholding statement to the withholding agent for allocating payments of income to the beneficial owners and for determining the ap-plicable withholding rates. If the NQI has provided all the above information, the U.S. withholding agent may generally withhold and report based on the in-formation provided by the NQI. Information reporting is made by the withholding agent to each beneficial owner on a separate Form 1042-S rather than under the pooling approach generally applicable to pay-ments made by U.S. withholding agents to QIs.

If the NQI does not provide the above information to the U.S. withholding agent, the U.S. withholding agent must withhold the maximum NRA withholding rate (30 percent) on all U.S. sourced FDAP income. Unallocated payments (i.e., the remaining amounts after allocation based on the withholding statement took place) are reported on a separate Form 1042-S as paid to an unknown account holder, with with-holding generally determined under the applicable presumption rule.338

Withholding and reporting for payments to with-holding partnership/withholding trust (WP/WT). U.S. withholding agents generally do not withhold NRA taxes on a foreign partnership or trust that have provided a valid Form W-8IMY indicating their status as a withholding partnership or a withholding trust. Withholding partnerships and trusts must assume primary withholding responsibilities. The income paid to the WP or the WT will be reported on Form 1042-S with zero-percent taxes withheld.339

Withholding and reporting for nonwithholding partnership/nonwithholding trust (NWP/NWT). The treatment of a nonwithholding partnership (NWP) or a nonwithholding trust (NWT) is generally similar to the treatment of a NQI. The NWP or the NWT should pro-vide the withholding agent with names of all partners/beneficiaries, together with applicable documentation of their status and a withholding statement containing an allocation schedule for each payment of income. If the NWP or the NWT does not provide the above information to the U.S. withholding agent, the U.S. withholding agent must generally withhold in accor-dance with the applicable presumption rule.340

Portfolio interest, foreign targeted bearer obligations, registered obligations. Code Secs. 871(h)(1) and 881(c)(3) generally exempt from NRA withholding interest payments (including OID) on foreign targeted bearer obligations and registered obligations.341


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Foreign targeted bearer obligations. A bearer obligation is one that is not in registered form. The bearer obligation is foreign targeted when it meets the following three requirements: (i) there are arrangements to ensure that the obligations are not sold to U.S. persons; (ii) payment of in-terest is made outside the United States and its possessions; and (iii) the face of the obligation states that any U.S. person who owns the obliga-tion will be subject to U.S. taxation.342 Registered obligations. An obligation is registered when it meets the requirements specified in Reg. §1.871-14(c). Among these requirements is that the withholding agent obtain a withholding certifi-cate or documentary evidence that the beneficial owner of the payment is not a U.S. person. Such documentation must be provided before expira-tion of the beneficial owner’s limitation period for claiming a refund with respect to such interest.343 This documentation requirement does not apply in cases of foreign targeted registered obligations, which have separate requirements.344 Exceptions. The following are interest income pay-ments that do not qualify for the portfolio interest exemption even when the interest is paid with respect to a registered or foreign targeted bearer obligation: (i) interest that is paid to a foreign person who owns 10 percent or more of the entity paying the interest, (ii) interest that is paid to a foreign bank on the extension of credit made pursuant to a loan agreement entered into in the ordinary course of the bank’s trade or business, (iii) interest that is paid to a foreign controlled corporation from a person related to that foreign controlled corporation, or (iv) contingent interest paid to a foreign person.345

U.S. financial institution—Consideration of pay-ments to foreign vendors. Many U.S. financial institutions are multinational corporations that make payments to foreign persons in a proprietary capacity. Therefore the examiner should review their payments to foreign vendors and other related and unrelated foreign persons for possible withholding tax and reporting requirements.346

Suggested initial information document requests (IDR). The information document requests are pro-vided as a general guide to the examiner and are recommended that they be adapted by the examiner to fit the needs of the audit.

Request 1. The examiner should request copies of Forms 1042 and Forms 1042-S, along with supporting documentation.

Request 2. The examiner should request infor-mation relating to policies and procedures of fiduciary (custodial) accounts. Areas covered should include account opening, documenta-tion validation, renewal of Forms W-8, sourcing and characterization of income. The examiner should consider requesting operating manuals, and interviewing relevant personal. Request 3. The CAS, with the assistance of the examiner, should attempt to identify all systems involved in any aspect of processing and tracking transactions that are potentially subject to NRA withholding and reporting. Some withholding agents may use many different systems, so con-sideration should be given to requesting data flow diagrams at a system’s level. Request 4. The CAS, with the assistance of the examiner, should attempt to identify the systems along with the specific files or tables to be used as sources of information needed to identify all pay-ments potentially subject to NRA reporting and or withholding. Special consideration should be given to ensuring all payments requiring special treatment by the withholding agent are accounted for through the custodial systems.

Nonfinancial Institutions Withholding Agent Audits (Payments of FDAP U.S. Sourced Income to Foreign Persons)

The audit will focus on companies or other entities that make payments to foreign persons in their busi-ness activities in connection with obtaining services or the use of property or financing. Commonly, the relationship is one of a payer for services rendered by foreign persons (vendor payments). Many of these payments can be expected to have been affected or recorded by an account payable or similar depart-ment. When payments made to a foreign vendor consist of U.S. sourced income, there will generally be reporting and withholding tax requirements. There is an additional reporting requirement with respect to certain U.S. taxpayer’s transactions with related foreign persons. These transactions will be reported on Forms 5471 and 5472.347

Introduction. U.S. entities that make payments in a proprietary capacity to foreign persons for services or other entitlements may have NRA withholding and reporting requirements. For example, this may occur when a U.S. entity makes a payment to a foreign ven-

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dor in exchange for U.S. sourced services. Another fact pattern illustrating these responsibilities is as follows. A large multinational pharmaceutical company pays royalties to a foreign company for drugs it sold within the United States. The royalty payments would typi-cally constitute U.S. source FDAP income to a foreign company. Therefore, the income would be subject to NRA reporting (Forms 1042 and Form 1042-S), and a NRA withholding tax of 30 percent absent a valid treaty or ECI related claim. In addition to payments to foreign vendors of U.S. source FDAP income, there are other payments that may generate NRA withholding and reporting (i.e., dividend payments). The exam-iner should examine all material payments to foreign persons as possible U.S. sourced FDAP income pay-ments. The below sections provide a three-step audit procedure to determine payments that may generate NRA withholding and reporting responsibilities.348

Payments to foreign vendors—Three-step audit procedure. The examiner can use these procedures to test if payments made by the accounts payable department and other departments making payments to foreign persons require NRA reporting and with-holding. The majority of these payments will be made to foreign vendors by the accounts payable depart-ment. Therefore, the examiner should obtain from the taxpayer the following: (i) the account payable file and similar files that contains all vendor payments, and (ii) the vendor record (file containing all vendor names and vendor information).

In order to determine those payments that are sub-ject to NRA reporting and withholding tax, steps one and two require analysis of the taxpayer’s accounts payable file and vendor file. It is recommended that a Computer Audit Specialist (CAS) be requested to assist in each of these three steps: (i) determining all foreign vendors, (ii) determining all payments of FDAP income to them, and (ii) determine any such FDAP Income (from step two) that is U.S. sourced and the applicable withholding rate, if any.

Line-by-line review of a withholding certificate (i.e. Form W-8) is necessary to ensure that the form is complete and consistent on its face. Note that a failure on any one line item does not necessarily invalidate the certificate and all claims made therein. However, the examiner should consider such failures carefully and shall take special caution in the case of systemic failures. It should also be noted that, in general, an invalid Form W-8 cannot be perfected by other sup-porting documentation. The examiner should exercise sound judgment in applying these guidelines.349

Determine all foreign vendors (step 1). This first step requires the analysis of the vendor file to identify vendors that may be foreign persons. The vendor file is a listing of all vendors, including names and other pertinent information relating to the vendor. All vendors who meet one or more of the following criteria should be considered to be a possible foreign vendor: (i) ven-dor’s EIN starting with 98-xxxxxxx; (ii) vendor’s ITIN starting with 9xx-7/8x-xxxx; (iii) address fields: country: not U.S. or blank, zip code: not U.S. format, state: not a U.S. state or blank, City: foreign city; (iv) vendor number, if coded for foreign vendors; and (v) any other factors which indicate possible foreign status.

The above are recommended indicators to determine that the vendor may be foreign. The examiner should review the vendor file to set any other criteria that may be used for the particular taxpayer. Some of the vendors selected may be U.S. vendors. Therefore, it is recommended that this list of possible foreign vendors should be presented to the taxpayer for their review. If the taxpayer can establish that the vendor is not foreign, the name should be removed from further review.350

Determine all payments of FDAP income to foreign vendors (step 2). In step two, payments to foreign ven-dors are ascertained. Not all payments to the foreign vendors selected in step one would be FDAP income. The examiner should decide which payment would most likely result in FDAP income to the vendor. Some of the most common expenses paid by the taxpayer that may result in FDAP income payments to the ven-dors are (i) interest; (ii) royalties, patents, copyrights (intellectual assets); (iii) royalties—natural resources (timber, oil, coal); (iv) personal service fees, wages; (v) annuities and pensions; and (vi) rents. The above is not an all-inclusive list of possible expenses, which may result in FDAP income payments to the foreign person. The examiner should consider the facts and circumstances of each taxpayer in determining all possible payments which may result in FDAP income to the foreign person.

It is recommended that the examiner should first test the accuracy of how expenses are categorized by the taxpayer before step two is performed. Often expenses are not accurately categorized by the tax-payer. For example, some portion of a large contract for computer hardware might pertain to training and maintenance functions. That portion would be personal service fees, which would be FDAP income if performed within the United States but the entire payment may have been incorrectly treated as com-puter hardware expense by the taxpayer.


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Once the examiner has determined the validity of the categorization, the step two’s analysis can be performed. The examiner should at least review ma-terial payments that may be FDAP even though the taxpayer did not correctly categorize them as such. The examiner should compile all payments of the selected expenses paid to the foreign vendors.351

Determine foreign vendors’ FDAP Income that was U.S. sourced (step 3). At this point the examiner has determined payments to foreign vendors which are FDAP income. The source of the income (U.S. sourced versus foreign sourced) should now be de-termined. Reg. §1.1441-2(a) requires that the income payments be presumed U.S. source when the source is not known to the payer. Therefore, any FDAP income determined in step 2 that the source is unknown to the payer is presumed to be U.S. sourced and subject to a 30-percent withholding tax. The taxpayer has the burden of proof to overcome the presumption. 352

Notional Principal Contracts. Industry Directive on Total Return Swaps (TRS) Used to Avoid Dividend Withholding Tax

As noted above, on July 29, 2008, the IRS added to the IRM §4.10.21.8 as guidance for examining agents to use to determine whether a financial institution has complied with its withholding and reporting ob-ligations under Code Sec. 1441. See “U.S. Financial Institution Withholding Tax Audit.”

Notional principal contracts (NPC). More spe-cifically, examining agents were directed to IRM §4.10.21.8.7.6 when auditing notional principle contracts which provided the following far-from-clear advice:

There is no NRA withholding obligation on pay-ments made under NPCs to foreign persons.353 If, however, these payments are ECI as to the foreign person, or are presumed so under the regulations, income reporting is required on Form 1042-S.354 The ECI presumption may be rebutted by a with-holding certificate representing that the payments are not effectively connected with the conduct of a U.S. trade or business. Instead of a withholding tax certificate, a payee may represent in a master agreement governing the transactions in NPCs between the parties that the counterparty is a U.S. person or a non-U.S. branch of a foreign person. Income on NPC’s that are regarded as embedded

interest or recharacterized as certain other pay-ments under U.S. tax principles might be subject to NRA withholding and reporting.355

LMSB issues industry directive on total return swaps. On January 14, 2010, the LMSB issued an industry directive entitled, “Industry Directive on Total Return Swaps (TRSs) Used to Avoid Dividend Withholding Tax”356 regarding the examination of U.S. financial institutions. For this purpose, a “U.S. financial institution” is defined as a “domestic orga-nization that provides financial services and financial products” and U.S. branches of foreign banks.

At least one commentator has suggested the IRS intends to assert deficiencies against the financial insti-tutions who presumably have the deep pocket and not directly against the non-U.S. persons on the basis that the equity swaps constituted disguised agency relations more akin to a broker-dealer relationship. In such case,

Table 2.

Sourcing Rules Type of Income

Determinative factors (as may be modi-fied or excluded by an applicable treaty)

Personal Services

Generally where services are performed, subject to potential allocation under Reg. §1.861-4 and to a limited exclusion based on temporary U.S. presence. Even for U.S. source income, withholding under Code Sec. 1441 is not required to the extent the compensation is subject to withholding as wages.

Dividends Generally depends on whether paying corporation is domestic or foreign.

Interest Generally depends on whether payor is domestic or foreign (where Incorporated). Interest paid by a U.S. branch of a foreign corporation is U.S. source income. Code Sec. 884(f)(1)(A). For original issue dis-count, see Code Sec. 871(g)(3).

Rent Where the property is locatedRoyalties, Patents and Copyrights

Where the property is used (benefits derived)

Royalties- Natural Resources

Where the property is located

Pensions Generally depends on where the related services were performed, though earnings on a U.S. plan are U.S. source income. For allocating between employer contri-butions and earnings for defined-benefit pension plans, See Rev. Proc. 2004-37. Also reference the income exclusion pro-vided under Code Sec. 871(h) for certain payments from qualified annuity plans under Code Sec. 403(a)(1).

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the financial institutions would have the duty to with-hold as the withholding agent.357 The IRS refers to these guidelines as industry director directive or “IDD”).

Purpose of TRS guidelines. This industry director directive (IDD) is intended to provide the field with guidance and information document requests (IDR) for uncovering and developing cases related to TRS trans-actions that may have been executed in order to avoid tax with respect to U.S. source dividend income paid to non-resident alien individuals, foreign partnerships and foreign corporations (each, a “foreign person”). Such dividend withholding tax avoidance transactions have recently been identified as part of a new Tier I issue, U.S. Withholding Agents—Reporting and Withholding on U.S. Source FDAP Income. Some taxpayers and withholding agents contend that the payments made pursuant to certain transactions are foreign source pur-suant to Reg. §1.863-7 and therefore are not subject to U.S. withholding tax and Form 1042-S reporting.

The intent of this IDD is to provide guidance on developing facts for determining when a transaction that is in form a TRS will be respected in substance as a notional principal contract, and when such a swap will be recharacterized in accordance with its substance as an agency agreement, repurchase agreement, lending transaction, or some other form of economic benefit by the Foreign Person.

The purpose of this IDD is to provide guidance for teams examining the withholding tax obligations of U.S. financial institutions (including U.S. branches of foreign banks) that engaged in TRS transactions with foreign persons. Agents examining the income tax liabilities of such foreign persons under Code Secs. 871 and 881, as well as the withholding liabilities, may use this IDD as a resource in the development of those cases.

One commentator358 as summarized the IDD as follows:

The IDD principally focuses on transactions in which a foreign investor terminates its investment in a U.S. dividend-paying stock which retaining identical economic exposure to the stock through the TRS. Subsequently, the TRS is terminated and the foreign investor reacquires the physical posi-tion in the same stock. In the interim, a dividend is paid on the stock and the foreign investor receives a dividend equivalent under the TRS that is not subject to withholding tax, assuming the form of the transaction is respected. However, the Direc-tive also addresses situations in which the foreign

investor never makes a physical investment in the equity or equities underlying the TRS.

Examination guidance. This IDD describes four factual situations, each of which presents a varia-tion of a typical TRS transaction. After describing the basic facts of each situation, this IDD instructs the field how to proceed with an examination of each situation. In situations in which this IDD recom-mends that the field pursues an examination, the field should develop facts showing that the form of the TRS should be disregarded for U.S. federal income tax purposes or recast as “an agency agree-ment, repurchase agreement, lending transaction or some other form of economic benefit” by the foreign investor. In these situations, the field is directed to develop facts supporting a legal conclusion that the Foreign Person retained ownership of the reference securities for U.S. federal income tax purposes even though the foreign person may have transferred the legal title to such securities.

The four factual situations described in this IDD are representative examples of common variations of TRS transactions. The field should note that particular transactions under examination may not fit exactly within any one of the four situations discussed below. In such examinations, the field is instructed to use one or more of four situations and recommendations de-scribed in this IDD to tailor its examination of the facts and circumstances of a specific transaction. Thus, one total return swap informal document request (TRS IDR) template is provided for each of the situations.359

The four situations are (1) cross-in/cross-out with the same parties executing both the TRS and purchase/sale of the underlying equity; (2) cross-in/inter-dealer broker out involving a third party inter-dealer broker as an intermediary to effectuate a cross-out; (3) cross-in/foreign affiliate out involving an affiliate of the dealer-counterparty to effectuate the cross-out; and (4) a foreign investor who never owns the equity or equities underlying the TRS. The IDD provides templates or pro forma information document requests or IDRs for the first three situations which the examining agent is directed to use to obtain information regarding TRSs from taxpayers during the audit.

According to at least one commentator:360

The Directive also discusses the types of facts that indicate that the form of a TRS should not be respected. For example, the Directive discusses the use of “MOC” (market on close) and “MOO”


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(market on open) pricing for both the termination payment under the TRS and the foreign investor’s reacquisition of the underlying equity from the TRS counterparty. The IRS views this risk elimination strategy as the equivalent of a cross-out because the buyer and seller in these markets ‘know that their respective sales price and purchase price will be exactly the same.’ The Directive also indicates that the IRS views the use of an inter-dealer bro-ker as “prima facie” evidence of a cross-out and that it maintains a list of such brokers that have participated in these transactions.

Situation 1 (cross-in/cross-out). A foreign person owns an equity security issued by a publicly traded U.S. corporation (a “U.S. equity security”).361 The U.S. corporation pays regular and/or extraordinary dividends with respect to the U.S. equity securities. The field needs to determine whether these payments by the U.S. financial institution to the foreign person give rise to a tax liability of the foreign person under Code Secs. 871 or 881 and whether the U.S. financial institution or the foreign person has a withholding obligation under Code Secs. 1441, 1442 and 1461. The foreign person sells its U.S. equity security to a U.S. financial institution acting as a broker-dealer.

Simultaneously, the foreign person enters into a TRS with the same U.S. financial institution as the swap counterparty. The TRS references the same U.S. equity securities sold to the U.S. financial institution by the foreign person and the notional amount of the TRS equals the fair market value of the U.S. equity securi-ties sold to the U.S. financial institution. Pursuant to the terms of the TRS, the foreign person is required to make payments to the U.S. financial institution based on an interest component (such as a LIBOR-based pay-ment) and any depreciation with respect to the notional investment in the U.S. equity securities (an “equity equivalent position”). The U.S. financial institution is required to make payments to the foreign person in an amount equal to any appreciation with respect to the notional investment in the U.S. equity securities and any dividend paid with respect to the U.S. equity securi-ties (a “synthetic issuer position”). Payment obligations with respect to the equity equivalent and synthetic is-suer positions may be netted against each other.

The simultaneous sale of U.S. equity securities and acquisition of an equity equivalent position pursuant to a TRS is referred to below as a “cross-in.” The foreign person holds the equity equivalent position in the swap over the record date or dates.362 After the record date

or dates, the foreign person terminates the swap and at the same time repurchases the U.S. equity securities from the U.S. financial institution (also described be-low as a “cross-out”). The fair market value of the U.S. equity securities on the cross-in, and the repurchase price on the cross-out, are likely to be determined in such a manner that insures the foreign person has no pricing risk on the cross-in and the cross-out, but retains the overall ownership risk in the U.S. equity securities. To determine the notional principal amount of the TRS and the appreciation or depreciation with respect to the U.S. equity security referenced by the TRS, the documents may reference the same pricing mechanism (e.g., market on close (MOC)) or may require the use of a single interdealer broker, or the circumstances may show that the parties are likely to be in the market together upon a cross, particularly where the volume is typically low and the number of market participants is limited based upon a pattern of dealing or other relevant facts.

The meaning of an MOC buy order or MOC sell order should be determined by reference to the rules of the relevant exchange on which the securities are traded. For example, see the New York Stock Exchange Rule 123C Relating to Market-on-Close Policy and Expiration Procedures. The MOC orders eliminate risk because the buyer and seller know that their respective sales price and purchase price will be exactly the same. Usually, MOC orders are guaranteed to be executed if placed before a certain time for at least one exchange and virtually certain of occurring for other exchanges. Because MOC orders eliminate pricing risk, the use of MOC to calculate the termination payment under the TRS and to determine the purchase price of the U.S. equity security reacquired by the foreign person is equivalent to a “cross-out.” In addition to MOC, U.S. financial institutions and foreign persons may have used other strategies that eliminate price risk by using the same price calculation method to determination the final settlement of the swap and to determine the purchase price of the stock sold in the cross-out. These price calculation methods may be based on objective benchmarks such as VWAP (Volume Weighted Average Price) or MOO (Market on Open), which uses the first price of the trade day.

Past examinations suggest that for the periods current-ly under exam, relatively few TRS transactions involving potential U.S. dividend withholding tax avoidance will have been structured precisely as described above. Nonetheless, audit teams should continue to pursue examinations of these types of transactions. To facilitate

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such investigations, the field is directed to issue Total Return Swap Fact Pattern One Information Document Request (“TRS IDR #1”) to help identify these abusive transactions in an efficient manner.

TRS IDR #1 will help audit teams identify those transactions where the foreign person maintained control over the equity securities that creates an agency relationship between the Foreign Person and the U.S. financial institution, where the foreign person maintained elements of beneficial ownership resembling a sale and repurchase agreement363 or other similar arrangement, or where the transaction may be treated in substance as a securities lending transaction, loan, or other similar arrangement. TRS IDR #1 attempts to collect all relevant facts, whether obvious or not, such as:

whether any agreement or some other under-standing or arrangement, written or not, (an “Arrangement”) under which the U.S. financial institution would return the stock to the foreign person at the termination of the swap; and whether the foreign person and the U.S. finan-cial institution used a pricing mechanism that eliminated the pricing risk with respect to the U.S. equity security.

The field may also wish to consider the following factors indicating that the foreign person remained the beneficial owner of the U.S. equity securities during the term of the TRS:

Voting rights maintained by foreign person—Whether the foreign person maintained voting rights in some fashionVoting rights held by financial institution but controlled by foreign person—Whether the U.S. financial institution cast any votes with respect to the U.S. equity securities held as a hedge of its position under the TRS and whether such votes were independent of the foreign person’s instruc-tions or controlU.S. financial institution agreed to hedge its position in a particular manner—Whether con-tractual provisions or other formal or informal arrangements, expressly written or not, existed that required the U.S. financial institution coun-terparty to hedge its position under the swap in a particular manner (i.e., by holding the physical underlying reference security)Cost of hedge borne by foreign person—Whether contractual provisions or other formal or informal arrangements existed, expressly written or not, that required the foreign person to bear the U.S.

financial institution’s cost of hedging its synthetic issuer position

The examining agent is directed to determine the existence of an arrangement on a case-by-case basis, with the assistance of counsel, depending on the facts and circumstances. No one single fact or fact pattern is considered a controlling fact or fact pattern, and different facts will exist in different cases. The field agents are also directed to gather all of the available facts and then develop a conclusion with counsel.

Notwithstanding these factors and the specific in-formation requested pursuant to the TRS IDR #1, the field is directed to consider any other facts, including the following:

Foreign person did not convey ownership in the securities. The foreign person has not divested its beneficial ownership interest in the U.S. equity securities. Form over substance. The form of a TRS does not match the substance of the transaction. Financial institution acted as agent of foreign person. The U.S. financial institution acted as an agent for the foreign person by holding the U.S. equity securities. In addition, the field agents are directed to use TRS IDR #1, any other IDR described herein, and interviews to examine trans-actions that resemble the facts outlined in Situation 1 even when the transaction under examination does not include every fact mentioned above.

The Greenberg & Traurig Tax Alert had the follow-ing comments regarding the IRS characterization of Situation#1:364

Many seasoned tax professionals would have concerns that the substance of a transaction structured in this manner would be taxed as a disguised agency relationship. Although the Swap Audit Guidelines are not entirely clear, it appears that the IRS is also concerned about equity swaps that do not entail actual cross-ins and cross-outs but in which ostensible market transactions contain mechanisms that result in cross-ins and cross-outs.

For example, suppose the non-U.S. person executes a market sale of the stock at the incep-tion of the swap. At the same time, the financial institution is in the market purchasing stock to hold as a hedge of its obligations under the swap. Notwithstanding the simultaneity of the purchase and sale, if volume in the stock is robust


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in comparison to the number of shares that are referenced in the swap, it would be coincidence, at best, if the non-U.S. person sold to the financial institution (or vice versa at swap termination).

The Swap Audit Guidelines state that swap pricing mechanisms that assist the parties in avoiding price risk between the holding of the stock and the swap can be viewed as evidence that “the parties are like-ly to be in the market together upon a cross.” These pricing mechanisms include referencing a single interdealer broker price, market on close (MOC), market on open (MOO) and volume weighted average price (VWAP). This mandate is clearly a case of “no good deed goes unpunished.” The IRS rationale is that each of the pricing mechanisms, if available for the stock purchase or sale, would enable the parties to have certainty as to their purchase and/or sale prices of the stock. Indeed, the IDR for these transactions asks for the identity of transactions in which the swap reference price “and the prices at which the U.S, equity security was sold or purchased in the cross-in or cross-out are the same prices or are based on the same prices, such as MOC or VWAP.” Accordingly, in the view of the IRS, if the equity swaps references these prices, there would not be any slippage in moving between the stock and the swap.

It is interesting to note that many financial institu-tions began using MOC, MOO and VWAP for swap initiation and termination pricing for the specific purpose of ensuring that there was economic risk inherent for their swap counterparties in moving from a physical stock position to a swap. Without these mechanisms, the non-U.S. person could simply have asked for swap pricing equal to the price at which it sold the stock and the financial institution would price the stock at swap termina-tion at the price at which it disposed of its hedge. The IDR to be provided to financial institutions seeking to find cross-in/cross-out transactions asks whether pricing mechanisms that eliminated price risk were in place with respect to the equity swap. Prior the promulgation of the Swap Audit Guide-lines, the author’s own view was that the use of MOC, MOO and VWAP swap pricing would not have mandated a “yes” answer to this question.365 It is much more difficult to obtain a particular price than it is to reference the price at which the parties actually executed purchases and sales.

In addition to pricing, the IDR included in the Swap Audit Guidelines asks about other factors that could indicate an agency relationship. Spe-cifically, it asks:

whether there was a written or oral agreement for the financial institution to return stock to the non-U.S. person at the swap termination, whether the non-U.S. person had the right to direct voting of any stock held by the financial institution as a hedge of the swap, if the financial institution did vote any shares of stock held as a hedge of the swap, were such votes independent of the counterparty’s instructions, and whether there a written or oral agreement by the financial institution to hedge the swap in a particular way.

Again, interestingly, the Swap Audit Guidelines ask whether there was a written or oral agreement for the counterparty to bear the cost of any hedg-ing by the financial institution under the swap. The answer here should always be, “Only if the trader was doing his job correctly.” This question misinterprets the role of financial institutions in the swaps markets. Financial institutions do not generally enter the swaps markets for the purpose of taking any risk other than counterparty risk. The institutions have a unique ability to execute and hedge risks. If the costs of hedging increase, this is a cost that is usually borne by the client, not the financial institution. Accordingly, if a financial institution is acting a dealer, it will price hedg-ing into the swap and retain the ability to either terminate the swap if hedging costs increase or to pass along such costs to its clients.”

Situation 2 (cross-in/IDB out). The facts of Situa-tion 2 are the same as Situation 1 except that when the foreign person terminates the swap and crosses out, the foreign person reacquires the U.S. equity securities from a third-party who is not an affiliate of the U.S. financial institution (an “Unaffiliated Third-Party”) rather than from the U.S. financial institution that was a counterparty to the swap.

In examining a transaction that resembles Situation 2, the field is directed to develop facts showing the existence of an arrangement involving the foreign person and the U.S. financial institution, the unaffili-ated third party or both, with respect to the foreign

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person’s repurchase of the U.S. equity securities. When the examination identifies a transaction where the parties entered into such an arrangement, the field is directed to complete the examination in the same manner as described in Situation 1. If the field, after examination, does not find such an arrangement, the examination should be concluded.

In one variation of these transactions the U.S. fi-nancial institution or the foreign person engages an inter-dealer broker (an “IDB”) to act as an intermedi-ary to facilitate the cross-out to the foreign person. At the conclusion of the transaction, the U.S. financial institution will sell the U.S. equity securities to an IDB and the IDB will sell the U.S. equity securities to the foreign person. The IDB usually receives some type of small fee or spread for its participation, but the economic impact of an IDB is the same as cross trades that eliminate the pricing risk (the amount due under the TRS will be exactly equal to the amounts due from sale of the U.S. equity securities) for both the foreign person and the U.S. financial institution. The use of an IDB may provide prima facia evidence of an arrangement because IDBs are in the business of standing between two parties to a transaction. Further, the use of an IDB may show a pattern of dealing or course of conduct indicating that a U.S. financial institution has used a third party to facilitate the cross-outs with respect to other TRSs.

In developing the facts in the examination, the audit teams should issue Total Return Swap Fact Pat-tern Two IDR (“TRS IDR #2”), which seeks to target information indicating that an Arrangement existed whereby the U.S. financial institution coordinates the foreign person’s reacquisition of the U.S. equity securities through the unaffiliated third party.

TRS IDR #2 attempts to collect all relevant facts, whether obvious or not, such as the following:

Small commission—Whether the U.S. financial institution received an unusually small commis-sion in connection with any tradesLack of fees to unaffiliated third parties—Whether the U.S. financial institution paid or received any fees to the unaffiliated third partyPresence of repurchase agreement for securities—Whether the foreign person and the U.S. financial institution entered into any formal or informal agreements, understandings, side letters, contracts, or otherwise formulated an arrangement, written or not, with respect to the foreign person reacquir-ing the U.S. equity security upon the termination of a TRS. If such an arrangement is demonstrated

through responses to TRS IDR #2 or interviews, the audit team is directed to proceed with the examination as directed under Situation 1.


No conveyance of underlying securities. The foreign person has not divested its beneficial ownership interest in the U.S. equity securities. Form over substance. The form of a TRS does not match the substance of the transaction. U.S. financial institution is agent. The U.S. financial institution acted as an agent for the foreign person by holding the U.S. equity securities. Agreement to repurchase securities by foreign person. The foreign person, the U.S. financial in-stitution and/or the unaffiliated third party had an arrangement with respect to the reacquisition of the U.S. equity securities by the foreign person. In addition, the field is directed to use TRS IDR #2, any other IDR described herein, and interviews to examine transactions that resemble the facts outlined in Situation 2 even when the transaction under examination does not include every fact mentioned above.

The Greenberg Traurig Tax Alert had the following comment concerning Situation 2:366

The most important acknowledgement by the IRS in its discussion of cross-in/IDB out equity swaps is the direction that if an agent does not find an arrangement in which the IDB was acting as the proverbial “fig leaf” over the cross-out, “the ex-amination should be concluded.” In other words, this statement is an acknowledgement by the IRS that a one-way cross, without more, should not be viewed as a disguised agency relationship. This implicit determination comports with the posi-tion being advocated by most in-house financial institution tax departments that in the absence of a transfer and return of stock, no agency relation-ship should be considered to exist.”

Situation 3 (cross-in/foreign affiliate out). The facts of Situation 3 are the same as Situation 1 ex-cept that the Foreign Person enters into a TRS with a foreign affiliate of the U.S. financial institution (“Foreign Affiliate”) as the swap counterparty. To eliminate or substantially reduce its risk with respect to its position under the TRS, the Foreign Affiliate


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enters into a mirror swap with the U.S. financial institution. Finally, when the foreign person termi-nates the swap, the foreign person repurchases the U.S. equity securities from the Foreign Affiliate or the U.S. financial institution.

With respect to the facts discussed in Situation 3, the field is directed to follow Total Return Swap Fact Pattern Three IDR (“TRS IDR #3”) to develop facts related to these transactions in a manner that is consistent with the guidance provided in Situation 1. Specifically, the field is instructed to develop facts with respect to both the TRS entered in by (i) U.S. financial institution and the Foreign Affiliate, and (ii) the Foreign Affiliate and the foreign person.


No divestiture of securities by foreign person. The foreign person has not divested its beneficial ownership interest in the U.S. equity securities. Form over substance. The form of a TRS does not match the substance of the transaction. U.S. financial institution is agent. U.S. financial institution acted as an agent for the foreign person by holding the U.S. equity securities.

Reg. §1.1441-7(a)(1) defines a “withholding agent” as “any person, U.S. or foreign, that has control, receipt, custody, disposal, or payment of an item of income of a foreign person subject to withholding ... .” Both the U.S. financial institution and the Foreign Affiliate may satisfy the definition of a withholding agent with respect to the dividend payments. In ad-dition to examining the U.S. financial institution, the field may wish to consult the withholding on foreign payments technical advisor for guidance with respect to the examination of the Foreign Affiliate and the foreign person.

In addition, the field is directed to use TRS IDR #3, any other IDR described herein, and interviews to examine transactions that resemble the facts outlined in Situation 3 even when the transaction under exami-nation does not include every fact mentioned above. For example, in other variations of this Situation 3, the foreign person repurchases the U.S. equity securi-ties from the U.S. financial institution, another party related to the U.S. financial institution or a third-party seller of securities who act as an accommodation party on behalf of U.S. financial institution. In the event that the field discovers such transaction, the field is directed to use TRS IDR #2.

Situation 4 (fully synthetic). The facts of Situation 4 are the same as Situation 1 except that the Foreign Person has never owned the U.S. equity security referenced by the TRS. To eliminate or substantially reduce its risk with respect to its position under the TRS, U.S. financial institution hedges its synthetic issuer position under the swap. When the foreign person terminates the swap, it does not purchase the reference securities from the U.S. financial institution or any other broker-dealer.

Absent additional exceptional facts as discussed below, the field should not pursue such transactions. Treasury regulations provide different tax consequenc-es for different investment arrangements by providing different source rules for dividends paid with respect to physical long positions in an U.S. equity security and for dividend equivalents paid pursuant to an equity equivalent position held synthetically through notional principal contracts that reference the same U.S. equity security. The existing notional principal contract rule, found in Reg. §1.863-7, is clear on its face; taxpayers and withholding agents may rely on that rule when their investment is in substance and form a notional principal contract.

The field, however, should pursue transactions re-sembling Situation 4 when certain facts indicate that the foreign person exercised control with respect to the U.S. financial institution’s hedge and, therefore, may have obtained beneficial ownership of the U.S. equity securities as a result of entering into a TRS.

Size of reference stock so large as to compel financial institution to hold hedge. In particu-lar, when a foreign person holds a TRS position that is so large or so illiquid that a U.S. finan-cial institution acting as the swap counterparty must acquire the underlying security itself to hedge its synthetic issuer position under the swap, the foreign person may be considered the beneficial owner of the reference U.S. equity securities. Referenced stock is a hedge. Transactions in which the U.S. financial institution hedged its synthetic issuer position by retaining the physi-cal underlying reference securities on its books. Passage of voting rights to foreign person. Trans-actions in which the foreign person maintained voting rights with respect to the physical underly-ing reference securities. Foreign person must post collateral equal to at least 50 percent of initial value of shares.367 The foreign person was required to post collateral

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equal to at least 50 percent of the initial value of the shares referenced by the equity swap.368

Transactions in which the U.S. financial institution cast any votes with respect to the physical underlying reference securities in a manner directed formally or informally by the swap counterparty. The field is directed to use Total Return Swap Fact Pattern Four IDR (“TRS IDR #4”) and interviews to help identify these abusive cases in an efficient manner. Finally, the field should consider all the facts and circumstances to determine whether a particular transaction that is in form a notional principal contract constitutes a legitimate swap agreement in substance.

The Greenberg and Traurig Tax Alert had the fol-lowing comments related to Situation 4:369

A number of financial institutions have been offering so-called “synthetic prime brokerage” platforms. In a synthetic prime brokerage transac-tion, the financial institution allows the non-U.S. person to access its trading operations through a computer and enter a position that it desires to have economic exposure with respect to. The agreement in place between the financial institution and the non-U.S. person specifically states that each position posted on the system by the non-U.S. person will be treated as a swap transaction. The Swap Audit Guidelines note that synthetic prime brokerage transactions do not pose any price risk to the financial institu-tion. Although, in the author’s view, the taking of market risk is inconsistent with the role that financial institutions take in the equity derivative markets, the IRS’s position is understandable when the non-U.S. person is effectively executing the hedge transaction for the financial institution, on essentially one-to-one (delta one) basis. This level of execution raises issues as to whether the transaction should be treated as a notional prin-cipal contract for federal income tax purposes. The Swap Audit Guidance tells IRS agents to consider whether this absence of involvement by the financial institution causes the non-U.S. person to be treated as the owner of the hedge. In fact, the Swap Audit Guideline tells auditing agents to consider subpoenaing prime brokerage account statements for non-U.S. persons who have used this technique.

In summary, the Swap Audit Guidelines evidence a sophisticated approach to when swaps should

be taxed as custodial arrangements. Although the IRS does have additional work to do, it clearly has learned a lot about the over-the-counter securities business through the audits that it has conducted and through industry personnel who have joined the IRS in recent years. The Swap Au-dit Guidelines, however, are likely to substantially increase the duration and complexity of financial product audits.

Another commentator370 had the following caution-ary language after the issuance of the IDD:

Foreign investors may begin to see increased audit activity as a result of the Directives’s instruction that agents coordinate the examinations of the financial institutions with the examinations of the foreign investors. Any such audits, however, should potentially become more focused and predictable as a result of the Directive. Notwith-standing this greater clarity, financial institutions and hedge funds should proceed with caution when considering the types of swaps they execute and when preparing or considering appropriate guidelines for this activity. Although the Directive only discusses TRSs on equity, the IRS could apply the criteria set out in the Directive to non-equity TRSs. As such, taxpayers might look to various rules and safe harbors put forth in the Directive, recently enacted legislation (the HIRE Act), and the “red flags” that were highlighted in the September 2008 “Dividend Tax Abuse” report of the Senate Permanent Subcommittee on Investigations.

TRSs referencing equity securities issued by pri-vately held U.S. corporations. The field is instructed to examine any transaction where the foreign person entered into a TRS that references an equity security issued by a privately held U.S. corporation371 (a “TRS Referencing Private Securities”). The field should pursue any TRS Referencing Private Securities where the structure of the transaction resembles any of the transactions described above in Situations 1 through 4. In addition, the field should pursue any other TRS Referencing Private Securities structured in a man-ner that is not specifically described in this IDD. In a TRS Referencing Private Securities, the foreign person likely maintains control with respect to the reference private securities such that the foreign person may be considered the beneficial owner of reference securities. In the examination of a TRS


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Referencing Private Securities, the field is directed to develop facts necessary to support a challenge to such transaction similar to the challenge described above in Situation 4.

TRS executed using an automated program trading offered by the U.S. financial institution. The field is instructed to examine any transaction where the for-eign person entered into a TRS using an automated program trading offered by the U.S. financial institu-tion. The automated program trading would allow the foreign person to simultaneously and automati-cally trigger the U.S. financial institution’s execution, acquisition, and disposition of the TRS and the U.S. equity securities. The use of such automated program trading allows the foreign person to effectively control when and how the U.S. equity securities’ acquisition and disposition are executed, with the U.S. financial institution assuming no risk with respect to the pricing. In such a case, the foreign person may be considered the beneficial owner of reference securities. The field should examine these transactions in light of the four situations discussed in this directive.

TRSs referencing a portfolio of U.S. equity securi-ties. In the event that the field examines a transaction in which the TRS references a basket or portfolio of U.S. equity securities, the field should seek the assis-tance of the industry counsel and technical advisor.

Audit techniques. The field always has the re-sponsibility to monitor the statute of limitations on assessment under Code Sec. 6501, whether for a Form 1042 or any other income tax return. In the examination of TRSs used to avoid withholding tax with respect to dividends, the field is directed to is-sue the four IDR templates specific to TRSs asking the taxpayer and/or the withholding agent to identify and provide information with respect to all transac-tions that satisfy the criteria set forth in those IDRs. In addition, the field is reminded to issue “Model IDR for Withholding Strategy 1 and 2” with respect to any new examination of TRS transactions. However, the field should not be constrained by the five-day period mentioned in Model IDR for Withholding Strategy 1. In the examination of TRSs, the field must make a referral to a financial products specialist, a computer analyst specialist, and an international examiner. Finally, the field should consider whether relevant information may be obtained through other applicable methods including, but not limited to, the use of third-party summonses, such as the foreign person’s prime brokerage account, and interviews of all appropriate parties, including members of the

U.S. financial institution’s information technology departments to identify the computer programs used to execute TRSs and acquire and dispose of the U.S. equity securities. The field should coordinate these examinations with the teams that may be examining the foreign persons who executed the TRSs with U.S. financial institutions.

The field should analyze all possible transactions, particularly those that use MOC pricing and those transactions referencing a security that paid an ex-traordinary dividend. Additionally, there are known IDBs that facilitate these transactions. The examples listed herein are not intended to be exhaustive; the field should pursue other appropriate audit tech-niques as determined on a case by case basis.372

Liability for Withholding Tax, Interest, Penalties and Statute of LimitationsWithholding Agent Liability for Chapter 3 and Chapter 4 TaxIt is unclear under the new law if all or part of these provisions will be applicable to withholding tax imposed by Chapter 4 or whether the Treasury will adopt any safe harbor presumptions from the FDAP withholding tax rules which will ease the administra-tive burden upon withholding agents. Presumably, the Treasury will impose both strict rules and significant liability on a Chapter 4 withholding agents who fails to withhold regardless of whether any actual tax li-ability exists to the payee to ensure compliance with the new law given its legislative purpose to curb offshore tax evasion by U.S. persons.

Liability for InterestUnder the FDAP withholding tax rules interest is imposed on the amount that should have been with-held under Code Sec. 1441. Interest generally begins to accrue beginning on the last day for paying the tax due under Code Sec. 1461, which is March 15, the due date of the Form 1042 and ends on the date that the appropriate documentation is provided to the withholding agent to the extent withholding is not required.373 For any remaining tax liability, the interest continues to accrue until the tax liability is satisfied. If the tax liability and interest on that tax liability is satisfied by the beneficial owner of the pay-ment, the interest charge imposed on the withholding agent will be abated to the extent that interest is paid

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by the beneficial owner to avoid a double interest charge.374 The withholding agent is not relieved of any applicable penalties in such situation.375 Presumably, the IRS will buckle these interest rules into the new withholding tax and reporting regime.

New Six-Year Statute of Limitations Applies to Chapter 4 Withholding Taxes

Under the present law, taxes are generally required to be assessed within three-years after a taxpayer’s return was filed.376 If an assessment is not made with the required time period, additional tax liabili-ties cannot be assessed or collected at any future time. However, if there is a substantial omission of income of an amount equal to or greater than 25 percent of the gross income reported on the return, the three-year statute of limitations is extended to six years.377

The new law authorizes a new six-year statute of limitations for assessments of tax on understatements of income attributable to foreign financial assets. This new six-year statute of limitations differs from the existing six-year statute of limitations which remains unchanged. It should also be noted that the six-year extension does not extend the period for filing a re-fund claim for a tax return. Under Code Sec. 6511, a taxpayer has three years from the date he files his return or two years from the date he pays the tax, whichever is later to file a claim for refund.

Under the new six-year statute of limitations, the limitations period will be extended from three years to six years if the taxpayer omits from gross income an amount properly includible on his tax return, and such amount is in excess of 25 percent of the amount of the gross income stated in the return or such amount is attributable to one or more assets with respect to which information is required to be reported under new Code Sec. 6038D (or would have been required if this provision were applied without regard to the $50,000 dollar or other dollar threshold specified by the Secretary, or to any excep-tion for nonresident aliens or any exceptions provide by regulation) and the gross income is in excess of more than $5,000.

If a domestic entity is formed or availed of to hold foreign financial assets it is subject to the report-ing requirements of Code Sec. 6038D in the same manner as an individual and the six-year statute of limitations period also applies to that entity.

The Secretary is permitted to assess the resulting deficiency at any time within six years of the fil-ing of the income tax return. By providing that the Code Sec. 6038D information reporting require-ments are to be determined without statutory or regulatory exceptions, the new law ensures that the longer limitation period applies to omissions of income with respect to transactions involving foreign financial assets owned by individuals. Thus, a regulatory provision that alleviates duplicative reporting obligations by providing that a report that complies with another provision of the Code may satisfy one’s obligations under new Code Sec. 6038D does not change the nature of the asset subject to reporting. The asset remains one that is subject to the requirements of Code Sec. 6038D for purposes of determining whether the exception to the three-year statute of limitations applies.378

The provision also suspends the limitations period for assessment if a taxpayer fails to provide timely information returns required with respect to pas-sive foreign investment corporations379 and the new self-reporting for foreign financial assets. Both the three-year and new six-year limitations periods will not begin to run until the information required by those provisions has been furnished to the IRS.

The extended statute of limitations is effective for returns filed after March 18, 2010, and if the statute of limitations was still open for the return on March 18, 2010, for returns filed before March 18, 2010 (e.g., for any returns filed after the date of enactment or for any other returns for which the assessment period under Code Sec. 6501 has not yet expired as of the date of enactment).380 This means that income tax returns for calendar-year taxpayers for the 2006, 2007, 2008, 2009 and 2010 tax years are potentially subject to the new six-year statute rather than the traditional three-year statute unless the Treasury provides guidance otherwise. See “Income tax return reporting for foreign financial assets” and “Penalty for failure to disclose foreign financial assets.”

Significant Changes to Three-Year Statute of Limitations Under the HIRE Act for Failure to Disclose Foreign Transfers

Act Sec. 513(c) of the HIRE Act simply states, “Paragraph (8) of [Code] Section 6501(c) is amend-ed by striking “event” and inserting “tax return, event.” The Joint Committee explanation states


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that the provision “clarifies that the extension is not limited to adjustments to income related to the information required to be reported by one of the enumerated sections.”381

One commentator382 has focused on the of addition of the two words “tax return” to Code Sec. 6501(c)(8) (which is entitled, statute on limitations on as-sessments and collection-failure to notify Secretary of certain foreign transfers) by stating:

This addition may have significant consequences to the tolling of the assessment statute of limita-tions for tax years of companies in the tax return reporting of international operations.

Section 6501(c)(8) provides an exception to the general rule that taxes are to be assessed within three years after a taxpayer’s return is filed. Prior to its recent amendment, [Code Sec.] 6501(c)(8) extended the assessment statute if a taxpayer failed to provide information about certain cross-border transactions until three years after the required information is actually provided to the Secretary. More specifically, [Code Sec.] 501(c)(8) stated that “[i]n the case of any information which is required to be re-ported to the Secretary under [Code] Sec. 6038, 6038A, 6038B, 6046, 6046A, or 6048,383 the time for assessment of any tax imposed by this title with respect to any event or period to which such information relates shall not expire before the date which is three years after the date on which the Secretary is furnished the information required to be reported under such section.” In other words, the assessment statute of limita-tions is extended if a taxpayer fails to provide any information required on Forms 5471, 5472, 926, 8621, 8865 and 3520,384 and the three-year statute of limitations does not start until all required information is provided.

Change to Code Sec. 6501(c)(8). The HIRE Act added the words “tax return” such that the relevant portion of the provision now reads as follows:

[T]he time for assessment of any tax imposed by this title with respect to any tax return, event, or period to which such information relates shall not expire before the date which is three years after the date on which the Secretary is furnished the information required to be reported under such section.

What does this mean? The assessment statute of limitations is extended if a taxpayer fails to provide any information required on Forms 5471, 5472, 926, 8621, 8865 and 3520. The extension is not limited to adjustments to income related to the in-formation required to be reported on one of these forms, but rather the Internal Revenue Service can assess any additional tax that may be due on any tax return (e.g., Form 1120 - U.S. Corporation Income Tax Return). This change to [Code Sec.] 6501(c)(8) is characterized in the Joint Committee’s technical explanation of the HIRE Act as a clarification.385 This contradicts the preamble to regulations issued in 2000 under [Code Secs.] 6038 and 6038B, which stated that the extended statute of limitations provided by [Code Sec.] 6501(c)(8) remains open only with respect to “tax consequences related to the information required to be reported under the relevant reporting section and not to all transactions with the U.S. person’s tax year at issue.386 [Code Sec.] 6501(c)(8), as amended, if effective for returns for which the assessment statute of limitations is open after 18 March 2010 … .”

Technical Correction proposed. On July 28, 2010, House Ways and Means Committee Chair-man Sander M. Levin (D-MI) introduced H.R. 5893, the Investing in American Jobs and Closing Tax Loopholes Act of 2010, which among other tax proposals would make a technical correction to the HIRE ACT that would clarify the circumstances when the statute of limitations provision under Code Sec. 6501(c) can be tolled if the failure to comply with the filing requirements is due to rea-sonable cause and is not willful. In cases in which a taxpayer establishes reasonable cause the limita-tions period will be suspended only for the item or items related to the failure to disclose and not all issues with respect to the income tax return.387 In order to prove reasonable cause, it is anticipated that a taxpayer must establish that the failure was objectively reasonable (i.e., the existence of ad-equate measures to ensure compliance with rules and regulations) and in good faith.388 The Staff of the Joint Committee on Taxation provided the fol-lowing example389 to illustrate the application of the provision in a prior proposal in the American Jobs and Closing Tax Loopholes Act of 2010:

[T]he limitations period for assessing taxes with respect to a tax return filed on March 31, 2011

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ordinarily expires on March 31, 2014. In order to assess tax with respect to any issue on the return after March 31, 2014, the IRS must be able to establish that one of the exceptions applies. If the taxpayer fails to attach to that return one of mul-tiple information returns required, the limitations period does not begin to run unless and until that missing information return is supplied. Assuming that the missing report is supplied to the IRS on January 1, 2013, the limitations period for the entire return begins and elapses no earlier than three years later on January 1, 2016. All items are subject to adjustment during that time, unless the taxpayer can prove that reasonable cause for the failure to file the information existed. If the taxpayer establishes reasonable cause, the only adjustments to tax permitted after March 31, 2014 are those related to the failure to file the information return. For this purpose, related items include (i) adjustments made to the tax consequences claimed on the return with respect to the transaction that was the subject of the in-formation return (ii) adjustments to any item to the extent the item is affected by the transaction even if it is otherwise unrelated to the transaction and (iii) interest and penalties that are related to the transaction or the adjustments made to the tax consequences.

Penalty for Failure to Disclose Foreign Financial AssetsIf an individual fails to furnish the Code Sec. 6038D required information on his tax return (beginning in his 2011 tax return) in the time and manner as required such person will pay a penalty of $10,000 for the tax year.390 (See “Income tax return report-ing for foreign financial assets.”) In addition, if the failure continues for more than 90 days after the day on which the IRS mails notice of such failure, such individual will be subject to an additional penalty of $10,000 for each 30-day period (or part thereof) during which such failure continues with such pen-alty not to exceed $50,000 for one taxable period.391 Thus, it would be prudent for taxpayers to determine whether the new reporting requirements apply to any investment or transaction in which a non-U.S. person is a party.

The computation of the penalty is similar to that applicable to failures to file reports with respect to certain foreign corporations under Code Sec. 6038.

Thus, an individual who is notified of his failure to dis-close with respect to a single tax year and who takes remedial action on the 95th day after such notice is mailed incurs a penalty of $20,000 comprising the base amount of $10,000, plus $10,000 for the frac-tion (i.e., the five days) of a 30-day period following the lapse of 90 days after the notice of noncompliance was mailed. An individual who postpones remedial action until the 181st day is subject to the maximum penalty of $50,000; the base amount of $10,000, plus $30,000 for the three 30-day periods, plus $10,000 for the one fraction (i.e., the single day) of a 30-day period following the lapse of 90 days after the notice of noncompliance was mailed.

One commentator392 has suggested the 90-day period and subsequent 30-day periods are too short by stating:

Americans who reside abroad and have received individual communications from the IRS have complained that they receive IRS mailings months after the date on the communication report and often after the deadline indicated for compliance. An automatic increase in the penalty can lead to totally unjustified penalties if the individual residing overseas does not receive the document within a time frame to allow him/her to study the issue, and if necessary, correct the reporting and pay the initial penalty.

In addition, this commentator also questioned the definition of “mailing” by stating:

What is the definition of “mailing” by the IRS – the date on the IRS document or the actual time that the document is put into U.S. postal system for mailing? Or does the IRS assemble mail and hold it for some time before actually initiating the mailing to a foreign location for further mail distribution? In some places in Af-rica, Latin America and Asia, it may take two months or more for a mailing from the United States to arrive. The law presumes that all mail sent to a foreign address will arrive within the same delays as those for U.S. addresses; this simply is not the case.393

If the IRS determines that an individual has an interest in an SFFA and such individual does not provide enough information to enable the Secretary to determine the aggregate value of such assets,


September 2010

then the aggregate value of such identified foreign financial assets will be presumed to have exceeded $50,000 or such higher amount as the IRS shall pre-scribe for purposes of determining the penalty.394

Application to certain entities. The new law makes clear Code Sec. 6038D return reporting will also ap-ply to any domestic entity which is formed or availed of for purposes of holding, directly or indirectly SFFAs in the same manner as if such entity were an individual as provided by the Secretary.395

Reasonable cause exception. However, no penalty will be imposed on any failure that is shown to be due to reasonable cause and not due to willful ne-glect. Foreign law prohibitions such as the fact that a foreign jurisdiction would impose a civil or criminal penalty on the taxpayer for disclosing the required information is not reasonable cause.396

Consequences of trying to avoid FATCA reporting and withholding. At a recent tax reporting and with-holding conference, a question was raised whether a taxpayer can fly ‘under the radar’ for a foreign entity he directly or indirectly controls by deciding not to have the foreign entity enter into a Code Sec. 1471(b) agreement with the IRS and thereby avoid filing an annual report of its U.S. accounts with the IRS in the case of a foreign financial institution, such as a offshore investment fund comprising family members and friends of family or deciding not to disclose the substantial U.S. owners or otherwise certify that there are no such owners for a non–financial foreign entity he controls. Presumably, his nonparticipating foreign financial institution and the non–financial foreign entity will be subject to a 30-percent withholding tax on any withholdable payments made to such entities (e.g., U.S. source FDAP income and on the gross proceeds from the sale of U.S. stock or securi-ties by such entities)..

For this purpose, a question arises whether the Treasury will treat an entity that is a disregarded entity under the check-the-box rules as a separate foreign entity subject to FATCA withholding and reporting. Presumably these entities will also be included as foreign entities under new Code Sec. 1474(5) to avoid abuse by taxpayers by using such entities. However, the Treasury may want to consider a kick-out rule for those disregarded entities where duplicative reporting and withholding may be required under new Codes Sec. 1471 or 1472.

Since a “financial account” as defined under new Code Sec. 1471(d)(4) will be included as a report-able “specified foreign financial asset,” or SFFA, an

individual taxpayer will have to attach a statement with his tax return for 2011 and forward under new Code Sec. 6038D. Thus, an individual taxpayer must report his interest in a foreign deposit or custodial account or his interest in non–publicly traded equity or debt of a foreign financial institution. Similarly, he must report as an SFFA any other stock or security issued by a non-U.S. person or his interest in any financial instrument or contract held for investment that has a foreign issuer as a counterparty and in any interest he has in a foreign entity as defined in new Code Sec. 1473.

This definition is broad enough to cover an indi-vidual taxpayer’s interest in non–publicly traded debt or equity of a non–financial foreign entity as well as for his debt and equity interest in foreign publicly traded entities, which would be excludable under new Code Sec. 1472(c). Similarly, if an individual taxpayer has an interest in a foreign entity that is ex-empt as a foreign financial institution, the language of new Code Sec. 6038(D) is broad enough to include these interests as SFFAs unless the Treasury provides guidance otherwise.

It is likely the IRS will take the position that if an individual taxpayer fails to identify all his SFFAs, in-cluding his interests in foreign financial institutions or non–financial foreign entities, then he has failed to file a complete tax return and therefore the statute of limitations (which would otherwise now be six years) remains open.

In cases where the failure to report was uninten-tional, the taxpayer may be able abate the penalty under new Code Sec. 6038D(d) and the new 40-percent accuracy related penalty (see “New penalty for underpayments attributable to undisclosed foreign financial asset”) if he can establish the failure was due to reasonable cause and not willful neglect.

In cases where the individual taxpayer intention-ally tries to avoid reporting his interest in foreign financial institution or non–financial foreign entity, it is likely the IRS will seek not only to impose civil fraud penalties, but the IRS (CI) or the DOJ may try to impose criminal penalties especially if the taxpayer has not reported the underlying income from these investments. While it is too early to tell, it is not too far of a reach to suggest that the new Code Sec. 6038D reporting statement may become the tool of choice for the next decade (akin to the FBAR now) to enforce criminal prosecutions against taxpayers who fail to report and pay their U.S. income taxes from their offshore accounts.

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Other Civil PenaltiesIn addition to liability for tax and interest a Chapter 4 withholding agent may be liable for significant civil penalties:

Information return reporting penalties—Code Secs. 6721 and 6722—Code Sec. 6721: Failure to file timely, correct, and complete information returns. Un-der Code Sec. 6721(a)(1), there is imposed a penalty of $50 for each return for which such failure occurs up total amount for all such failures during a calen-dar year not to exceed $250,000. For this purpose, a failure includes any failure to file an information return or any failure to include all of the information required on the return or the inclusion of incorrect information. There are certain exceptions that may mitigate this penalty, including (i) correction of fail-ure, (ii) correction of failure under the small business exception, and (iii) the de minimis exception.

Code Sec. 6721—Intentional failure to file. If there is an intentional disregard of the filing requirement the amount of the penalty will be the greater of $100 or 10 percent of the aggregate amount of the items required to be reported correctly (without regard to the $250,000 limitation) under Code Sec. 6045(a), 6041A(b), 6050H, 6050I, 6050J, 6050K or 6050L. In the case of a return required to be filed under Code Sec. 6045(a), 6050K or 6050L, five percent of the aggregate amount of the items required to be reported correctly. In the case of a return required to be filed under Code Sec. 6050I(a) with respect to any transaction (or related transactions) the greater of $25,000 or the amount of cash (within the meaning of Code Sec. 6050I(d)) received in such transaction (or related transactions) to the extent the amount of cash does not exceed $100,000. In the case of a return required to be filed under Code Sec. 6050V, 10 percent of the value of the benefit of any contract with respect to which information is required to be included on the return.

Code Sec. 6722—Failure to furnish timely, correct and complete payee statement. Under Code Sec. 6722, each failure by any person with respect to a payee statement will be subject to a $50 penalty for each statement with respect to which such failure occurs. The total amount imposed on such person for all such failures during a calendar year cannot exceed $100,000 per year. For purposes of this provision a failure includes (i) any failure to furnish a payee statement, or (ii) any failure to include all of the information required to be shown on a payee statement or the inclusion of incorrect information.

Code Sec. 6722—Penalty in case of intentional disre-gard. If one or more failures are due to the intentional disregard of the requirement to furnish a payee state-ment or the correct information reporting requirement, then, with respect to each failure, the amount of the penalty shall generally be the greater of $100 per state-ment or 10 percent of the aggregate items required to be reported and the $100,000 limitation will not apply. In the case of a payee statement required under Code Sec. 6045(b), 6050K(b) or 6050L(c), a lower penalty equal to $100 per statement or five percent of the ag-gregate items is required to be reported.

Code Secs. 6662 and 6663—Civil fraud penalties. A withholding agent’s fraudulent failure to report to the IRS income from one or more U.S. accounts, whether in the form of interest, dividends, capital gains or other income, may result in civil fraud penalties equal to 75 percent of the underpayment of tax that is attributable to fraud. Acquittal in a criminal prosecution is not decisive of the civil fraud issue. However, a criminal conviction for income tax evasion does decide the fraud issue and the subject are collaterally estopped from raising it in the civil proceedings.397

When a withholding agent is required to file a tax return and fraudulently fails to do so on or before the due date of the return, Code Sec. 6651(f) imposes a penalty of 15 percent of the net tax amount required to be shown on the tax return for each month (or fraction of a month) that the return is late.398 The maximum penalty is 75 percent.399

Code Secs. 6651(a)(2) (late payment penalty) and 6651(a)(3)—Civil penalty for failure to pay tax penalties. When a withholding agent fails to timely withhold and pay over the amount of tax shown on the return on or before the due date prescribed for payment, Code Sec. 6651(a)(2) imposes a late pay-ment penalty equal to 0.5 percent of the amount of the underpayment for the first month, with an additional 0.5 percent for each additional month or fraction thereof during which such failure continues. The maximum amount of the penalty cannot exceed an aggregate 25 percent.400 When a withholding agent fails to withhold and pay over a tax that is required (but was not) shown on a return within 21 days from the date of the IRS notice and demand for that tax, Code Sec. 6651(a)(3) imposes a penalty of 0.5 percent for each month (or part thereof) that the assessment remains unpaid. The maximum penalty is 25 percent.401

Code Secs. 7203 and 6651(a)(1) (delinquency penalty) for failure to file return—Criminal and civil


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penalties. If the withholding agent fails to file his or her income tax return, there may be a criminal penalty of up to $25,000 ($100,000 in the case of a corpora-tion), up to one year in prison or both.402 A delinquency penalty of five percent a month may be imposed when a tax return is filed delinquently without reasonable cause, or when a taxpayer fails to file a return without fraudulent intent. The penalty is limited to 25 percent and is imposed on the net amount due.403

In applying the Code Sec. 6651(a)(1) penalty to a withholding agent, the D.C. Circuit affirmed the Tax Court’s decision in Del Commercial Properties, Inc.,404 stating that a taxpayer “bears the heavy burden of proving that its deficiencies were due to reasonable cause and not willful neglect.”

New penalty for underpayments attributable to undisclosed foreign financial asset—Accuracy-related (negligence) penalty. The new law adds a new 40-percent accuracy-related penalty under Code Sec. 6662. The 40-percent penalty is imposed on any understatement of income attributable to an “undisclosed foreign financial asset,” subject to the same defenses as are otherwise applicable under Code Sec. 6662.

Under the new law, an asset is an “undisclosed foreign financial asset” if it is an asset subject to certain information reporting requirements,405 and the required information was not provided by the taxpayer during the relevant tax year. The informa-tion reporting requirements for this purpose, includes information reporting related to the following:

The new law’s requirement for an individual to furnish the “6038D required information” on his tax return in the time and manner as required406 (See “Income tax return reporting for Foreign Financial Assets.”)Controlled foreign corporations and partnerships407 Transfers to foreign corporations and partner-ships408

Certain organizations, reorganizations and acqui-sitions of stock in foreign corporations409 Certain acquisitions, dispositions of and substan-tial changes to interests in foreign partnerships410

Certain transactions involving foreign trusts411 (An understatement is attributable to an undisclosed foreign financial asset if it is attributable to any transaction involving such asset.)

Thus, a U.S. person who fails to comply with the various self-reporting requirements for a foreign financial asset and engages in a transaction with respect to that asset incurs a penalty on any resulting

underpayment that is double the otherwise applicable penalty for substantial understatements or negligence. For example, if a taxpayer fails to disclose amounts held in a foreign financial account, any underpay-ment of tax related to the transaction that gave rise to the income would be subject to the new penalty provision, as would any underpayment related to interest, dividends or other returns accrued on such undisclosed amounts. The effective date of the new 40-percent penalty is effective for tax years beginning March 18, 2010, i.e., 2011 for individuals.

Code Sec. 6662 civil accuracy-related (neg-ligence) penalty. Code Sec. 6662 continues to impose a 20-percent accuracy-related penalty if the underpayment is attributable to among other items, negligence or disregard of the rules or regulations or a substantial understatement of income tax or in the case of any undisclosed asset understatement.412 Negligence includes any failure to make a reason-able attempt to comply with the tax law and the term disregard includes any careless, reckless or intentional disregard.413 There is a substantial un-derstatement of income tax for any tax year if the amount of the understatement exceeds the greater of 10 percent of the tax required to be shown on the tax return for the tax year or $5,000.414 In the case of a C corporation other than a personal holding company or an S corporation, there is as substantial understatement if the amount of the understatement for the tax year exceeds the lesser of 10 percent of the tax required to be shown on the tax return for the tax year or $10 million.415 The negligence penalty cannot be assessed against any portion of the understatement against which the fraud penalty is assessed.416

Code Sec. 6672 (100-percent penalty). A 100-percent penalty equal to the total amount of tax evaded may be imposed on a withholding agent who is required to collect, truthfully account for and pay over any tax; and willfully evades, fails to collect, account for and/or pay over such tax or will-fully attempts in any manner to evade or defeat any such tax.417 No reported cases exist that apply the 100-percent penalty to a withholding agent under the FDAP withholding tax rules.

Code Sec. 6694 understatement of taxpayer’s li-ability. It is likely that some tax return preparers, as well as the general public, may not fully understand the new law and may not be fully compliant with the withholding and reporting requirements for every U.S. account. This raises the possibility that the tax

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return preparer penalty of Code Sec. 6694 may be applied by the IRS as well.

Under Code Sec. 6694, any tax return preparer who prepares a tax return or claim for refund with respect to which any part of the understatement of liability is due to a “unreasonable position” may have pay a penalty equal to the greater of $1,000 or 50 percent of the income derived by the tax return preparer.418 No penalty will be imposed if it shown that there is reasonable cause for the understatement and the tax return preparer acted in good faith.419

A position is treated as an unreasonable position unless (i) there is or was substantial authority for the position; or (ii) the position was properly disclosed and had a reasonable basis.420 There is substantial authority for a position if the taxpayer is subject of a “written determination” as provided in Treasury Regulation §1.6662-4(d)(3)(iv)(A).421

If a preparer of a tax return wants to take a posi-tion that a U.S. person did not have an interest in or a signature or other authority over a financial ac-count in a foreign country, such as a bank account, securities account or other financial account and not disclose the position on the return, the preparer must have “substantial authority” to avoid the Code Sec. 6694 penalty. If the preparer discloses the is-sue on the return, the preparer must also have a reasonable basis for this position on the return to avoid the penalty.

Penalty for Delinquent Deposits. The withholding agent may be liable for underpayment of deposits or fail-ure to make timely deposits.422 The penalty is two percent for failure of not more than five days, up to 10 percent for failure of more than 15 days, and could reach 15 percent if notice and demand is disregarded.423

Criminal PenaltiesCode Sec. 7206 criminal fraud and making false statements—Perjury penalty. If a withholding agent provides false information in connection with a return filing, the withholding person may be pros-ecuted for willfully making a false tax return that he does not believe to be true and correct as to every material matter under penalties of perjury. Filing a false return is a felony and is subject to a fine of up to $100,000 ($500,000, in the case of a corporation) and a prison term of up to three years or both.424 Thus, a person who knowingly provides false information regarding a U.S. account may face possible criminal prosecution which from the point of view of a prosecutor will be a relatively

simple case to prove when compared to trying to establish tax evasion in complex fact situations which are common in tax shelter schemes or other abusive transactions.

Code Sec. 7202 criminal penalty for failure to col-lect or account for and pay over tax. A withholding agent may be liable for a criminal penalty of up to $100,000 and/or five years imprisonment, plus the costs of prosecution for willful failure to collect or account for pay over tax.425

Code Sec. 7201 criminal attempt to evade or defeat tax. Under Code Sec. 7201, if a withholding agent will-fully attempts in any manner to defeat paying the U.S. tax on the income from a foreign financial account, a U.S. person may be guilty of a felony and may be fined up to $100,000 ($500,000 in the case of a corporation), imprisoned for up to five years or both.426

“U.S. Account” Exposures—Prophylactic Planning, Corporate Governance and Compliance to Manage Global U.S. Account Risk

Banks and other financial service companies as well as financial intermediaries may want to affir-matively plan to have their corporate governance and compliance shops in order before the govern-ment comes knocking on their door asking about its or its customers’ U.S. accounts or other accounts. What can banks and other financial service com-panies do now?

Conduct thorough due diligence and proactively manage the global U.S. account risk. It is unlikely that the UBS legal, compliance or tax groups knew about the cross-border private banking initiative to solicit American clients and set them up in offshore accounts to conceal their assets and income from the U.S. government. However, the behavior of one or more business groups can be imputed to the bank and to its directors and senior officers at the bank with the potential for both civil and criminal prosecution if the bank does not have robust compli-ance programs in place to avoid misconduct.427 It is necessary and prudent for banks and financial ser-vice companies to undertake their own compliance initiatives in 2010 to make sure they are compliant with the HIRE Act on its effective date generally on December 31, 2012.

The first step is for the legal, compliance or tax groups who make the “key” compliance decisions for investor compliance and recordkeeping and inves-


September 2010

tor documentation and information reporting to do a mock internal compliance health check to assess the efficacy of the existing qualified intermediary and investor documentation and information reporting processes. (E.g., does the bank know its customers under best-practice “KYC” principles, and has the bank made reasonable inquiries to verify its clients’ documentation (e.g., Forms W-8s, W-8BENs,W-8-IMYs or W-9s)428 and to assess the “quality” of the repositories holding information about its custom-ers global accounts and other proprietary debt and equity investments?)

As part of an audit under Chapter 3 and presum-ably Chapter 4, it is likely the IRS will review the U.S. payors’ or withholding agents’ written processes and procedures and will try to identify the accounts which are held by foreign persons or vendors and then look to the source of those payments. Existing reporting systems should be reviewed to ensure that the payments are sourced properly and that the in-formation reporting documentation for the accounts is proper. If there is conflicting information or files or information arising from other reporting systems or vendors, the processes and procedures for error resolution should be reviewed.

If information is not timely obtained about ac-counts, the processes and procedures to cure these foot faults should also be reviewed. Importantly, ascertaining whether the presumption rules and certifications by customers are handled correctly will also help in assessing the exposure for withhold-ing or backup withholding and the possible failure to identify payments subject to withholding. Also, are the controlled foreign corporations compliant with information reporting for their U.S. payees and others? If a company has been relying upon electronic signatures rather than getting a hard copy of each investor certification (e.g., W-8), this will likely create exposures. Lastly, the written internal procedures addressing know-your-customer and other information and reporting issues should be reviewed and as necessary robust manuals should be developed.429

As part of the evaluation it will be necessary to assess the human and capital resource needs to design and implement processes to satisfy the new reporting, compliance and recordkeeping for U.S. accounts on a global basis. For those foreign financial institutions that are already qualified intermediaries, every effort should be made to de-velop foreign account compliance processes that

will be buckled into the existing processes thereby generating synergies and cost savings. For those foreign financial institutions that are not already qualified intermediaries, new HIRE Act reporting and compliance processes will have to be designed and implemented which are in conformity with the Code Sec. 1471(b) agreements that they will likely enter into with the IRS by the effective date of the new legislation, December 31, 2012, un-less extended by the Treasury. Similarly, for those institutions that are non–financial foreign entities, processes will have to be developed to capture the account information required to avoid withholding under new Code Sec. 1472.

To give an idea of the scope of the undertaking, it may be helpful to identify on a rough macro basis the businesses which will likely be impacted by FATCA for a medium-size financial institution. The businesses will, include but not be limited to, bank-ing, fixed income, loan origination and syndication, equities, securitization, wealth management and high–net worth, including discount and full service brokerage, trustee and custodial services (personal trusts, funds, employer-sponsored plans, etc.), estate administration, investment management, custody, and retail mutual funds, international banking, insur-ance, which includes property, auto, travel, disability and critical illness, term life, universal life, deferred and life annuities, and segregated funds and capital markets. Presumably, each of the existing front office and back office systems, processes and procedures in, for example, information reporting, accounts pay-able, treasury, accounting , legal and compliance, technology, etc.) will have to be identified and an assessment made which systems, legal entities and accounts are impacted by FATCA.

The optimal solution may, in many cases, be a sys-tem that (i) automates the existing systems (e.g., QI or existing 1441 and U.S. reporting, AML/KYC, accounts payable, custodial reporting and documentation, etc.) and new systems, as required for satisfaction of the FATCA reporting and other requirements; and (ii) at the same time identifies the key drivers which may create substantial risk exposure for the firm and puts appropriate human and other resources (in terms of the appropriate number of people in the right loca-tions, appropriate segregation of duties for internal control and other purposes and level of experience among other considerations) in place to manage the risk process (e.g., timely identification of process and non–process FATCA withholding and/or reporting

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errors, ongoing testing, follow-up on remediation pro-cesses, privacy waiver issues and closing the accounts as necessary, disclosure and confidentiality issues, timely identification of material omissions and other footfalls, real time financial statement reserve analyses and documentation for reversals of such reserves and the rollout of new business platforms and assets which are FATCA compliant, etc.).

As part of this project, it will be a good idea to also get an independent internal or external third-party view and comments regarding best practices to imple-ment the new reporting and withholding regime on a global basis. The results of the due diligence for the bank’s existing information reporting system and recommendations by the bank’s advisors as to “best practices” and as to how best to satisfy the require-ments of the new law for the bank’s global accounts, including documentation and information reporting as well as the new required account verification and “know-your-customer” processes should be reviewed by the internal audit committee of the firm and recom-mendations should be made to senior management and to the Board of Directors as to how to how best to develop, implement and manage the new law requirements, information reporting and withhold-ing as well as to remedy any internal control gaps as quickly as possible.

Once a plan is fully developed, the working group should put together a time line to show how each step will be implemented to satisfy the new law’s effective date requirement.

Continued and on-going testing. On an on-going basis, a dedicated risk management group should be assigned to continue to test and be able to answer two questions on a continuing basis. First, if there were to be an audit by an external monitor akin to what UBS was required to recently undertake, would the financial institution have the processes and docu-mentation in place to support a favorable review? Second, will the bank be able to support the conclu-sion that the business groups both on- and off-balance sheet, including the private equity, alternative funds and structured product businesses are not setting up foreign accounts or structures which need to have FIN 48 or FAS 5 reserve exposures or which would require footnote disclosure on the audited financial statements or other SEC filings if all the facts are known with 20/20 hindsight?

Future U.S. account reporting and enforce-ment activity by the government. The reporting and recordkeeping requirements are likely to be expanded as the government moves forward in its initiatives to close the perceived tax gap as part of its international tax enforcement and anti–money laundering efforts directed at among other areas U.S. accounts which are owned by non-U.S. per-sons. The government can be expected to employ more resources into this area and to continue to expand its own audit and enforcement strategies which have garnered it so much good press. See “Recent Senate AML probe into foreign persons beneficial ownership of U.S. accounts.”

EndnotEs

1 Deborah Fields and Carol Kulish Harvey, New U.S. Law Imposes Withholding and Reporting Requirements on Foreign Partner-ships, Tax analysTs special reporT (May 24, 2010).

2 Kathleen Agbayani, Robert Albaral, Scott Frewign, Robert F. Hudson, Jr., Robber Kent, Jr., William J. Linklater, Richard M. Lipton, Marnin J. Michaels, Sigurd So-renson, Douglas M. Tween and A Duane Webber, Experiences with the ‘New’ Vol-untary Disclosure Program—Some Good, Some Bad, http://checkpoint.riag.com/app/servlet/com.tta.checkpoint.servlet.CPJSPServlet?usid=25a...

3 Code Sec. 6159; IRA L Shafiroff, IRS Practice & Procedure Deskbook, §5:15.1, Practising Law Institute (3rd ed. 2008).

4 www.alvarezandmarsal.com/newsletters/taw/taw2008-9.htm?camp=taw&div=tas&date=Feb25&desc=issue9.

5 Code Sec. 1463.

6 Code Sec. 6901.7 Jessica L. Everett Garcia, Dan Bagatell and

Thomas Johnson, Top 10 Issues to Consider When You Are Sued: Issue #8: Disclosing Litigation and Reserving for Litigation Losses, Apr. 11, 2007.

8 IR-2010-088 (Aug. 4, 2010).9 Tax Analyst Cod. 2007-10728 (Apr. 30,

2007) and Tax Analyst Doc. 2007-6222 (Mar. 2007); IRM §4.51.1 (“Rules of Engage-ment”).

10 “Issue Tiering Fact Sheet,” issued by the LMSB Division of the IRS (Mar. 18, 2009).

11 Id.12 EMISC Tier I 1441, “U.S. Withholding

Agents—§1441: Reporting and Withholding on U.S. Source FDAP Income” (undated); Mark Leeds, New IRS Audit Guidelines Target Equity Swaps with Non-U.S. Coun-terparties, greenbergTraurig Tax alerT, Jan. 2010 (hereinafter termed “Greenberg & Traurig Comments”), at 2.

13 Paul D. DeNard, “Industry Directive on Ex-aminations of Forms 1042,” Memorandum for Industry Directors, Oct. 31, 2003.

14 Code Sec. 881(c)(3)(A).15 IRM §4.10.21.8.7.7.16 Code Sec. 1473(4); Reg. §1.1441-7(a)(1). 17 www.irs.gov/businesses/small/international/

article/0,,id=96404,00.html.18 Rev. Rul. 2004-75, 2004-2 CB 109.19 New Code Secs. 1471(d)(4), 1472(d),

1473(5). 20 www.irs.gov/businesses/small/international/

article/0,,id=105154,00.html.21 Reg. §§1.1441-2(b); 1.306-3(h).22 William Young, Rom P. Watson and Robert

Church, Securities Lending, Repos, and Derivatives after FATCA, Executive Enter-prise Institute 22nd Annual Forum on Inter-national Tax Withholding and Information Reporting, June 17–18, 2010 (New York, New York).

23 New Code Sec. 1473(1)(A)(ii).


September 2010

24 Reg. §1.6045-1(a)(1).25 Laurie Hatten-Boyd, July 26, 2010, Web cast

sponsored by KMPG LLP. See also Marie Sapirie, Treasury Expected to Address FATCA Definitions, TNT, July 26, 2010 (hereinafter cited as “KPMG Webcast”).

26 Act Sec. 501(d)(1) of the HIRE Act.27 Act Sec. 501(d)(2) of the HIRE Act.28 EBF/IBB Comments, at 9–14. 29 Id.30 Laura M Prendergast, “Field Directive on the

Use of Estimates from Probability Samples,” Memorandum for Industry Directors, LMSB-4-0809-032, Nov. 3, 2009; Keith M. Jones, “Field Directive on the Use of Estimates from Probability Samples,” Memorandum for Industry Directors, Mar. 14, 2002.

31 Mary Batcher, Eric Falk, Wendy Rotz, New IRS Guidance Makes Statistical Sampling More Attractive than Ever for Federal Tax Purposes, 62 Tax execuTive 1 (Jan.–Feb. 2010), at 37–39.

32 Ann Noges, Foreign Account Tax Compli-ance Act Provisions in the Hiring Incen-tives to Restore Employment Act of 2010 (“FATCA”) comments to the Treasury submit-ted on behalf of the RBC Financial Group (June 30, 2010), hereinafter cited as “RBC Comments,” at 19.

33 Code Sec. 1471(d)(1)(A). 34 KPMG Web cast, at 1. 35 Code Sec. 1473(3).36 RBC Comments, at 6.37 Mary Richardson, Foreign Account Tax

Compliance (“FATCA”), alTernaTive invesT-MenT ManageMenT associaTion, June 29, 2010 (hereinafter cited as “AIMA Comments”).

38 UCITS branded paper has been used in this scenario but privately placed debt would be another example.

39 RBC Comments, at 11–13.40 RBC Comments, at 8–11. 41 RBC Comments, at 20–22.42 AIMA Comments.43 Code Sec. 1471(c)(1). 44 Code Sec. 1471(d)(1)(A).45 Code Sec. 1471(d)(3). 46 Code Sec. 1473(2)(B).47 Code Sec. 1473(2)(A).48 Code Sec. 1471(d)(1)(A).49 Code Sec. 1471(d)(1)(B)(ii).50 Code Secs. 1471(d)(1)(A), (d)(3), 1473(2)(A)

(i)–(iii).51 Code Sec. 1473(2)(B).52 Code Sec. 1471(d)(2).53 Code Sec. 1472(b).54 Code Sec. 1471(c)55 Code Sec. 1472(b).56 Code Sec. 1471(b)(1)(B).57 Code Sec. 1472(b).58 Code Sec. 1471(b)(1)(E).59 Code Sec. 1471(b)(1)(F).60 Code Sec. 1471(a), (b)(3).61 Code Sec. 1472(a).62 Code Sec. 1471(b).63 Code Sec. 1471(e).

64 Code Sec. 1472(b).65 The author added a refund section to the

Shawn McKenna’s chart.66 Chip Collins, Cyrus Daftary and Laurie

Hatten-Boyd, FATCA Session III—Strategic Planning, Systems Implications, Things the Treasury Needs to Know, etc., Executive Enterprise Institute 22nd Annual Forum on International Tax Withholding and Informa-tion Reporting, June 17–18, 2010 (New York, New York).

67 John Staples, FATCA—Session I—Overview, Section 1471 and 1472, Executive Enterprise Institute 22nd Annual Forum on Interna-tional Tax Withholding and Information Reporting, June 17–18, 2010 (New York, New York).

68 RBC Comments, at 19–20.69 RBC Comments, at 22.70 Patricia Roth, Comments Regarding the For-

eign Account Tax Compliance Act of 2009, Florida International Bankers Association (Apr. 30, 2010).

71 See, e.g., Reg. §§1.6042-3(b)(1)(iv) (treat-ing U.S. branches of foreign banks as U.S. payors or U.S. middlemen for purposes of interest payment reporting requirements), 1.6045-1(g)(3)(iii)(B)(1) (treating a sale ef-fected by a broker at an office outside the United States as a sale effected by a broker at an office inside the United States if the customer has opened an account with a U.S. office of that broker or a U.S. office of the broker negotiates the sale with the customer or receives instructions with respect to the sale from the customer), and 1.6049-5(c)(5)((i)(F) (treating U.S. branches of foreign banks as U.S. payors or U.S. middlemen for purposes of interest payment reporting requirements.

72 RBC Comments, at 15. 73 Code Sec. 1471(b)(1)(A) and (c). 74 Code Sec. 1471(b)(1)(F). 75 Code Sec. 1471(a); Code Sec. 1471(d)(6). 76 Code Sec. 1471(b)(1)(F)(ii). 77 Code Sec. 1471(b)(3).78 Code Sec. 1471(b)(1)(D)(i), (d)(7).79 Code Sec. 1471(b)(3)(C)(i), (ii). 80 Code Sec. 1471(b)(3)(C)(ii).81 Code Sec. 1471(d)(7).82 Code Sec. 871(a)(1)(A). Reg. §1.861-2(a)

(1).83 Code Sec. 871(a)(1)(A). Reg. §1.861-3.84 Code Sec. 1471(b)(3). 85 Code Sec. 1474(b)(1).86 Code Sec. 7701(b); (a)(30), (a)(4).87 Code Sec. 1471(d)(3). An FFI has a zero-

percent ownership threshold for a specified U.S. person to be a substantial U.S. owner—Code Sec. 1473(2)(B).

88 Code Sec. 1474(b)(2)(A).89 Code Sec. 1473(1).90 Code Sec. 1471(d)(5).91 Code Sec. 1472(d).92 Code Sec. 1472(b).93 Code Sec. 1473(2)(A).

94 It may be possible for a debt holder to become a substantial U.S. owner if the IRS adopts related party rules similar to Code Sec. 267(b), (C), 707(b) or 958(a), (b).

95 Code Sec. 1472(a).96 Id.97 Code Sec. 1471(d)(3).98 Code Sec. 1471(b)(3). 99 There is no analog rule in new Code Sec.

1474 similar to Code Sec. 1474(b)(2) for FFIs that explicitly permits an NFFE to obtain a refund or credit by reason of a U.S. treaty obligation.

100 Code Sec. 6038A(a). 101 Code Sec. 1471(d)(2). Any depository or cus-

todial account or any non–publicly traded equity or debt interest in a FFI.

102 Code Sec. 6038A(b). 103 The new law has a grandfather rule for the

treatment of outstanding obligations that provides that Chapter 4 shall not apply to any payments under any “obligation out-standing” after March 18, 2012, or from the gross proceeds from any disposition of such obligation.

104 New Code Sec. 1474(c)(1); Staff of the Joint Committee Technical Explanation for the Extenders Act, at 137; Code Secs. 3406(f) and 6103.

105 New Code Sec. 1474(c)(2); Staff of the Joint Committee Technical Explanation for the Extenders Act, at 137.

106 New Code Sec. 1474(e)(1); Code Secs. 3406(f), 7431.

107 Notice 2009-93, IRB 2009-51, 863.108 Comments on Notice 2009-93 Concerning

the Pilot Program to Truncate Taxpayer Iden-tification Numbers on Certain Payee State-ments, ABA Tax Section (July 22, 2010).

109 New Code Sec. 1474(d); Staff of the Joint Committee Technical Explanation for the Extenders Act, at 137.

110 Compare Act Sec. 101(b) of FATCA to Act Sec. 501(d) of the Extenders Act.

111 Staff of the Joint Committee Technical Expla-nation for the Extenders Act, at 137.

112 SIFMA Comments, at 9.113 New Code Sec. 1474(f); Staff of the Joint

Committee Technical Explanation for the Extenders Act, at 137.

114 ABA Tax Section Comments, at 11.115 See Act Sec. 501(d)(1) of the Extenders

Act; Staff of the Joint Committee Technical Explanation for the Extenders Act, at 138.

116 See Act Sec. 501(d)(2) of the Extenders Act; Staff of the Joint Committee Technical Explanation for the Extenders Act, at 138.

117 Act Sec. 101(d)(2)(B) of FATCA. 118 Sullivan & Cromwell Comments, at 7, foot-

notes 12, 13. 119 Notice 97-34, 1997-1 CB 422.120 Staff of the Joint Committee Technical Ex-

planation for the Extenders Act, at 138; JCT Explanation, at 49.

121 See Act Sec. 101(d)(1) of FATCA; Staff of the Joint Committee Technical Explanation for

124


FATCA, at 23.122 See Act Sec. 101(d)(2) of FATCA; Staff of the

Joint Committee Technical Explanation for FATCA, at 23.

123 NYSBA Tax Section Comments, at 10–11.124 EBF FATCA Comments.125 ABA Tax Section Comments, at 11.126 SIFMA Comments, at 3.127 EBF/IIB Comments at 24–27.128 31 CFR §103.27(c). The $10,000 threshold

is the aggregate value of all of foreign finan-cial accounts in which a U.S. person has a financial interest over which the U.S. person has signature or other authority.

129 IRM §4.26.16.3.2(1)(A–D). For an expanded explanation of the FBAR filing requirements, see Dean Marsan, FBAR Reporting Obliga-tions, Enforcement Exposures and Managing the Risk: What Every Tax and Compliance Advisor Needs to Know Now! Taxes, Nov. 2009, at 35.

130 New Code Sec. 6038D(a). 131 New Code Sec. 6038D(b). 132 New Code Sec. 6038D(c). 133 Marylouise Serrato and Jackie Bugnion,

Comments on Foreign Account Tax Compli-ance Act (FATCA) Provisions incorporated in the Hiring Incentives to Restore Employment Act (HIRE), American Citizens Abroad, June 14, 2010 (hereinafter “ACA Comments”).

134 Id.135 New Code Sec. 6038D(h). 136 Act Sec. 511(c) of the HIRE Act.137 Code Sec. 1297.138 Code Sec. 1291.139 Code Secs. 1293–1295.140 Code Sec. 1296.141 See Instructions to IRS Form 8621. Accord-

ing to the Form, reportable elections include the following: (i) an election to treat the PFIC as a QEF; (ii) an election to recognize gain on the deemed sale of a PFIC interest on the first day of the PFIC’s tax year as a QEF; (iii) an election to treat an amount equal to the shareholder’s post-1986 earnings and profits of a CFC as an excess distribution on the first day of a PFIC’s tax year as a QEF that is also a controlled foreign corporation under Code Sec. 957(a); (iv) an election to extend the time for payment of the shareholder’s tax on the undistributed earnings and profits of a QEF; and (v) an election to treat as an excess distribution requirements for certain PFIC shareholders, which is contingent upon the issuance of regulations. See Code Sec. 1291(e) by reference to Code Sec. 1246(f). Although the Treasury issued proposed regulations in 1992 requiring U.S. persons to file annually Form 8621 for each PFIC of which the person is a shareholder dur-ing the tax year, such regulations were not finalized and current IRS Form 8621 requires reporting only based on one of the triggering events described above. See Proposed Reg. §1.1291-1(i).

142 Notice 2010-34, IRB 2010-17, Apr. 6,

2010. 143 Code Secs. 871, 881, 1441, 1442. 144 Code Secs. 871, 881, 1441, 1442; Reg.

§1.1441-1(b). For purposes of the with-holding tax rules applicable to payments to nonresident alien individuals and foreign corporations, a withholding agent is defined broadly to include any U.S. or foreign per-son that has the control, receipt, custody, disposal or payment of an item of income of a foreign person subject to withholding. Reg. §1.1441-7(a).

145 Reg. §1.863-7(b)(1).146 Reg. §1.861-3(a)(6).147 Code Sec. 861(a)(2). 148 Reg. §1.863-7(b)(1). A notional principal

contract is a financial instrument that pro-vides for the payment of amounts by one party to another at specified intervals calcu-lated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts. Reg. §1.446-3(c)(1).

149 Reg. §1.861-3(a)(6). This regulation de-fines a “substitute dividend payment” as a payment made to the transferor of a secu-rity in a securities lending transaction or a sale-repurchase transaction, of an amount equivalent to a dividend distribution which the owner of the transferred security is entitled to receive during the term of the transaction.

150 For purposes of the imposition of the 30-percent withholding tax, substitute dividend payments (and substitute interest payments) received by a foreign person under a securi-ties lending or sale-repurchase transaction have the same character as dividend (and interest) income received in respect of the transferred security. Reg. §1.871-(7)(b)(2), 1.881-2(b)(2).

151 Notice 97-66, 1997-2 CB 328 (Dec. 1, 1997).

152 Department of the Treasury, General Expla-nations of the Administration’s Fiscal Year 2010 Revenue Proposals, May 2009, at 37.

153 Proposed new Code Sec. 871(l)(2) of FATCA; Staff of the Joint Committee Technical Expla-nation for FATCA, at 61.

154 Id.155 Securities Industry Financial Markets Asso-

ciation Comments on FATCA to the House Ways and Means Committee and Senate Finance Committee dated November 19, 2009 (hereinafter referred to as SIFMA Com-ments on FATCA), at 3–4.

156 SIFMA Comments on FATCA, at 4.157 SIFMA Comments on FATCA, at 4–5.158 SIFMA Comments on FATCA, at 4, footnote

4, provides:When the final regulations under Code Sec. 1441 were issued in 1997, the Treasury Department recognized this difficulty and decided to limit the withholding obligation where

the payor does not have custody or control over property owned by the recipient. In the Preamble to the final regulations, the Treasury Department explained that: “[s]everal comments were received regarding the difficulty for a withholding agent to withhold on an amount of income that is not represented by cash or property (i.e., deemed payments of income). The final Treasury regulations in §1.1441-2(d) provide relief in cases in which the withholding agent does not have custody of, or control over, property ...” T.D. 8734 (Oct. 6, 1997). Presum-ably in response to such comments, the final Treasury regulations §1.1441-2(d)(1) provide that “[a] withhold-ing agent who is not related to the recipient or beneficial owner has an obligation to withhold under Code Sec. 1441 only to the extent that … it has control over, or custody of money or property owned by the recipient or beneficial owner from which to with-hold an amount …”

159 SIFMA Comments on FATCA, at 5, footnote 5 provides, “The 30 percent tax on FDAP is imposed only upon a disposition of, or a distribution on, an original issue discount obligation.” Code Sec. 871(a)(1)(C), Reg. §1.1441-2(b)(3).

160 SIFMA Comments on FATCA, at 5, footnote 6 provides, “When the regulations under Code§1441 were finalized in October 1997, their effective date was initially set for Janu-ary 1, 1999.” T.D. 8734 (Oct. 6, 1997). The Treasury Department later extended the ef-fective date to January 1, 2000, explaining that “[t]he Department of the Treasury and the IRS believe it is in the best interest of tax administration to extend the effective date of the final withholding regulations to ensure that both taxpayers and the government can complete changes necessary to implement the new withholding regime.” T.D. 8804 (Dec. 31, 1998). The effective date of these regulations was then extended once again to January 1, 2001, which is more than three years after their original issue date. T.D. 8856 (Dec. 30, 1999).

161 SIFMA Comments on FATCA, at 5, footnote 7 provides:

More specifically, to build an equity swap withholding system would pre-sumably require at least the following: (i) allocation of a significant amount of information technology resources which requires budgeting and man-agement approval (ii) the creation of a project plan (iii) implementation of a project plan that would involve the following human resources: techni-cal tax, tax operations, information technology, settlement operations, business, legal, and controlling. (iv)


September 2010

preparation of a business require-ments document (v) creation of the functional specifications (vi) infor-mation technology programming (vii) testing. In addition to creating the withholding tax module for the swap payment system, there needs to be an integration of the swap payment system with the front-office systems, the general ledger for book-ing and controlling the withholding tax liabilities and the payments of the withheld tax to the IRS, the creation of a 1042-S reporting module, and a reconciliation process between the withheld taxes and the 1042-S report-able amounts.

162 SIFMA Comments on FATCA, at 3. 163 Proposed Code Sec. 871(l)(2)(B)(i)–(vi) under

FATCA; Staff of the Joint Committee Techni-cal Explanation for FATCA, at 61.

164 Staff of the Joint Committee Technical Expla-nation for FATCA, at 61.

165 SIFMA Comments on FATCA, at 2–3 and 6–7.

166 Notice 97-66. Specifically, U.S. withhold-ing tax on a substitute dividend payment is limited to the amount of substitute dividend multiplied by a rate equal to the excess, if any, of the U.S. withholding tax rate that would have been imposed on the recipient of the substitute payment, if the recipient had received the actual dividend payment directly, over the same rate applicable to the payor of the substitute payment. This amount is further reduced by actual withholding tax imposed on the underlying dividend or substitute dividend payments (if any) earlier in a chain of securities lending transactions. Notice 97-66, §3.

167 On November 17, 2009, at the Wall Street Tax Association Fall Tax Seminar, David Miller, Esq. from Cadwalader Wickersham & Taft compared the FATCA and Green Book Proposals to avoid the withholding tax for equity swaps.

168 New Code Sec. 871(l)(7).169 Green Book 2011 Proposal, at 48.170 Act Sec. 541(b) of the Extenders Act. 171 Act Sec. 841(b) of the HIRE Act.172 William Young, Rom P. Watson and Robert

Church, Securities Lending, Repos, and Derivatives after FATCA, Executive Enter-prise Institute 22nd Annual Forum on Inter-national Tax Withholding and Information Reporting, June 17–18, 2010 (New York, New York).

173 New Code Sec. 871(l)((3)(B) of the HIRE Act.

174 New Code Sec. 871(l)(3)(B); Staff of the Joint Committee Technical Explanation for the Extenders Act, at 169.

175 New Code Sec. 871(l)(1);Staff of the Joint Committee Technical Explanation for the Extenders Act, at 168.

176 Staff of the Joint Committee Technical Expla-

nation for the Extenders Act, at 168.177 Id.178 Id.179 New Code Sec. 871(l)(3)(A)(i).180 New Code Sec. 871(l)(3)(A)(ii).181 New Code Sec. 871(l)(3)(A)(iii); Cadwalader

HIRE Act Memo at footnote 16: “For this purpose, an index or fixed basket of securi-ties will be treated as a single security. The JCT Report provides such a security will be treated as regularly traded on an established securities market only if every component of the index or fixed basket is a security that is regularly tradable on an established securities market. See JCT Report, p.79.”

182 New Code Sec. 871(l)(3)(A)(iv).183 New Code Sec. 871(l)(3)(A)(v).184 New Code Sec. 871(l)(4)(A); Staff of the Joint


185 New Code Sec. 871(l)(4)(B); Staff of the Joint Committee Technical Explanation for the Extenders Act, at 169.

186 New Code Sec. 871(l)(4)(C); Staff of the Joint Committee Technical Explanation for the Extenders Act, at 169.

187 Id.188 Staff of the Joint Committee Technical Expla-

nation for the Extenders Act, at 169.189 New Code Sec. 871(l)(5); Staff of the Joint



191 Id.192 New Code Sec. 871(l)(6).193 Notice 97-66, 1972-2 CB 328.194 Staff of the Joint Committee Technical Expla-

nation for the Extenders Act, at 169.195 New Code Sec. 871(l)(7); Staff of the Joint

Committee Technical Explanation for the Extenders Act. at 169–70.


197 Cadwalader HIRE Act Memo, at 13–14. 198 Section 2(d)(i)(4) of the ISDA Master Agree-

ment.199 Section 5(b)(ii) and 6(b)(iv) of the ISDA Mas-

ter Agreement generally provide a party the right to terminate a swap if, as the result of a change in law (which generally includes the enactment or change of any law or change in the application or official interpretation of any law) after the date on which the swap was entered into, there is a substantial likelihood that the party will be required to pay the other party a gross-up payment in respect of taxes on the next scheduled pay-ment date.

200 Section 6(b)(i) of the ISDA Master Agree-ment.

201 Section 6(b)(ii) of the ISDA Master Agree-ment.

202 Cadwalader HIRE Act Memo, at 13–14, footnote 21 provides, “We do not believe that a transfer will successfully mitigate the

withholding imposed by the [HIRE] Act.”203 Section 6(b)(ii) of the ISDA Master Agree-

ment.204 Section 6(b)(iv) of the ISDA Master Agree-

ment.205 T.D. 8735, 1997-2 CB 72, 62 FR 53498

(1997).206 Reg. §§1.871-7(b) and 1.881-2(b)(2).207 See JCT Report, at 78, footnote 317, which

provides, in part:See United States Senate, Permanent Subcommittee on Investigations, Committee on Homeland Security and Governmental Affairs, Dividend Tax Abuse: How Offshore Entities Dodge Taxes on U.S. Stock Divi-dends, Staff Report (September 11, 2008), pages 18–20, 22–23, 40, 47, 52. In the Obama Administration’s fiscal year 2010 budget, the Treasury Department has announced that, to address the avoidance of U.S. with-holding tax through the use of secu-rities lending transactions, it plans to revoke Notice 97-66 and issue guidance that eliminates the benefits of those transactions but minimizes over withholding. Department of the Treasury, General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals, 2009, p.37.

208 Code Sec. 871(l)(2)(A).209 P.L. 111-152, 111 Cong. (Mar. 30, 2010). 210 These regulations will coordinate the tax

imposed on substitute payments under Code Sec. 871(l) and Reg. §§1.871-7(b)(2) and 1.881-2(b)(2) with the withholding and reporting requirements under Code Secs. 1441, 1442 and 1461 and the regulations there under to ensure that the appropriate amount of tax is paid and reported.

211 Code Sec. 163(a).212 An obligation is treated as in registered form

if (i) it is registered as to both principal and interest with the issuer (or its agent) and transfer of the obligation may be effected only by surrender of the old instrument and either the reissuance by the issuer of the old instrument to the new holder or the issuance by the issuer of a new instrument to the new holder; (ii) the right to principal and stated interest on the obligation may be transferred only through a book entry system maintained by the issuer or its agent; or (iii) the obligation is registered as to both principal and interest with the issuer or its agent and may be transferred through both of the foregoing methods. Reg. §5f.103-1(c).

213 Code Sec. 163(f)(2)(A). The registration requirement is intended to preserve li-quidity while reducing opportunities for noncompliant taxpayers to conceal income and property from the reach of the income, estate and gift taxes. See Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Tax Equity and

126


Fiscal Responsibility Act of 1982 (JCS-38-82), Dec. 31, 1982, at 190.

214 LTR 9343018 (July 29, 1993); LTR 9343019 (July 29, 1993); LTR 9613002 (Mar. 29, 1996). The IRS held that the registration requirement may be satisfied by “demate-rialized book-entry systems” developed in some foreign countries, even if, under such a system, a holder is entitled to receive a physical certificate, tradable as a bearer instrument, in the event the clearing orga-nization maintaining the system goes out of existence, because “cessation of operation of the book-entry system would be an ex-traordinary event.” Notice 2006-99, 2006-2 CB 907.

215 Code Sec. 163(f)(2)(B).216 Code Sec. 4701.217 Code Sec. 1287.218 Code Sec. 1287.219 Code Secs. 871, 881; Reg. §1.1441-1(b).

Generally, the determination by a withhold-ing agent of the U.S. or foreign status of a payee and of its other relevant characteristics (e.g., as a beneficial owner or intermediary, or as an individual, corporation or flow-through entity) is made on the basis of a withholding certificate that is a Form W-8 or a Form 8233 (indicating foreign status of the payee or beneficial owner) or a Form W-9 (indicating U.S. status of the payee).

220 Code Secs. 871(h) and 881(c). Congress believed that the imposition of a withholding tax on portfolio interest paid on debt obliga-tions issued by U.S. persons might impair the ability of U.S. corporations to raise capital in the Eurobond market (i.e., the global market for U.S. dollar-denominated debt obligations). Congress also anticipated that repeal of the withholding tax on portfolio interest would allow the Treasury Depart-ment direct access to the Eurobond market. See Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 (JCS-41-84), Dec. 31, 1984, at 391–92.

221 In repealing the 30-percent tax on portfolio interest, under the Deficit Reduction Act of 1984, Congress expressed concern about potential compliance problems in connec-tion with obligations issued in bearer form. Given the foreign targeted exception to the registration requirement under Code Sec. 163(f)(2)(A), U.S. persons intent on evading U.S. tax on interest income might attempt to buy U.S. bearer obligations overseas, claim-ing to be foreign persons. These persons might then claim the statutory exemption from withholding tax for the interest paid on the obligations and fail to declare the interest income on their U.S. tax returns, without concern that their ownership of the obligations would come to the attention of the IRS. Because of these concerns, Congress expanded the Treasury’s authority to require registration of obligations deigned to be

sold to foreign persons. See Joint Commit-tee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 (JCS-41-84), Dec. 31, 1984, at 393.

222 Code Sec. 871(h)(3). 223 Code Sec. 871(h)(4). 224 Code Sec. 881(c)(3)(C)225 Code Sec. 881(c)(3)(A). 226 31 USC §3121(g)(3). For purposes of Title 31

of the U.S. Code, “registration-required ob-ligation” is defined as any obligation except (i) an obligation not of a type offered to the public; (ii) an obligation having a maturity (at issue) of not more than one year; or (iii) a foreign targeted obligation.

227 31 USC §3121(g)(2). 228 ABA Tax Section Comments, at 3–4. 229 ABA Tax Section Comments, at 17–20.230 ABA Tax Section Comments, at 18, footnote

21 provides: “See PLR 9343018-9 (July 29, 1993); PLR 9613002 (March 29, 1996); Notice 2006-99, 2006-2 CB 907.“ See Reg. §1.163-5(c)(2)(i)(C) and (D).

231 ABA Tax Section Comments, at 18, footnote 22 provides, “Reg. §§1.163-5(c)(2)(i)(C) and (D).”

232 ABA Tax Section Comments, at 18, footnote 23 provides:

Under applicable Treasury regula-tions, an obligation is “in registered form” if (1) it is registered with the issuer or its agent as to principal and stated interest, and transfer may be effected only by surrender of the old instrument and the issuance of a new instrument or reissuance of the old instrument to the new holder; (2) the right to principal and stated interest may be transferred only through a book entry system maintained by the issuer or its agent; or (3) it is registered with the issuer or its agent as to prin-cipal and stated interest, and transfer may be effected through both of the preceding methods.

233 ABA Tax Section Comments, at 19, footnote 24 provides, “For this purpose, a lower ownership than provided in Code Sec. 957 might be appropriate.”

234 SIFMA Comments on FATCA, at 4.235 SIFMA Comments on FATCA, at 4–5.236 SIFMA Comments on FATCA, at 4, footnote

8 provides: “Section 102(d) and 101(d)(2)(A) of the Bill.”

237 SIFMA Comments on FATCA, at 4, footnote 9 provides: “Section 101(d)(2)(B) of the Bill.”

238 Green Book 2011 Proposals, at 56–57. 239 New Foreign Account Tax Compliance Rules

Under the Hiring Incentives to Restore Em-ployment (HIRE) Act, shearMan & sTerling clienT publicaTion, Tax, Mar. 26, 2010.

240 Such obligations would need to meet the following requirements: (i) the obligation would need to be issued under arrange-ments “reasonably designed to ensure” that

the obligation will not be sold (or resold) in connection with the original issue to a U.S. person; (ii) interest on the obligation would need to be payable only outside the United States and its possessions; and (iii) the obligation would need to be legended. Currently, a bearer bond issued in compli-ance with the TEFRA C rules is exempted from the legending requirement.

241 See Sullivan and Cromwell, Revised FATCA Plus Carried Interest Taxation Comments dated December 11, 2009 (hereinafter referred to as “Sullivan and Cromwell Comments”), at 11, footnote 25 provides, ”It is unclear how these provisions will ap-ply to foreign entities that apportion their worldwide interest expense to their U.S. branches or to entities that are controlled foreign corporations or PFICs for purposes of computing their earnings and profits and their U.S. shareholders subpart F income.”

242 Under Code Sec. 163(f)(2(B), interest must be payable outside the U.S. and its posses-sions, a legend must appear on he obligation stating that a U.S. person who holds the ob-ligation will be subject to limitations under U.S. income tax laws and “arrangements reasonably designed to ensure that such obligation will be sold (or resold in connec-tion with the original issue) only to a person who is not a U.S. person,” must be in place. See also Code Secs. 871(h)(2) and 881(c)(2)(A). This exemption, however, does not eliminate all sanctions on holders of foreign-targeted” bearer form obligations. In general, any gain recognized by a U.S. holder of a bearer form obligation that would have been a “registration-required obligation” had it not been issued in compliance with the foreign-targeting rules is treated as ordinary income (see Code Sec. 1287); and owners of such of such foreign-targeted obligations are not permitted to claim loss deductions on the sale or exchange of the instrument. See Code Sec. 165(j). See Sullivan and Cromwell Comments, at 10.

243 HIRE Act’s Foreign Account Tax Compliance Provisions, King & spalding alerT—Tax prac-Tice group (Mar. 26, 2010).

244 By reason of cross references, this rule will also apply to Code Secs. 165(j), 312(m), 871(h), 881(c), 1287 and 4701.

245 The issuance of physical certificates in bearer form in the event that the book entry system goes out of existence would be an extraordinary event that is not in the ordinary course of business. Notice 2006-99, 2006-2 CB 907. Sullivan & Cromwell Comments, at 11, footnote 26 provides, “We note, how-ever, that dematerialized obligations issued on or after January 1, 2007 are generally considered to be in registered form under current IRS practice. See Notice 2006-99, 2006-2 CB 907.“

246 Notice 2006-99, 2006-2 CB 907. The IRS will generally treat dematerialized obliga-


September 2010

tions issued after December 31, 2006, as being in registered form.

247 Sullivan & Cromwell Comments, at 11.248 NYSBA Tax Section Comments, at 13–15. 249 NYSBA Tax Section Comments, at 14, foot-

note 5 provides:In this regard, the use of the term “de-materialized obligation” may not be technically correct. It is apparent from the legislative history that the term was meant to include obligations that are in “global” bearer form, i.e., are represented by a single global note in bearer form that is held by a financial institution for the account of the obli-gation’s various beneficial owners and that trades through notations made in the records of the financial institution. As a technical matter, such global securities are not usually covered by the term “dematerialized”. Perhaps another term, “book-entry” securities, for example, could be used in the statute, or the legislative history could stat e that “global” securities would be considered “dematerialized” for this purpose.

250 Reg. §1.163-5(c)(1)(ii)(B).251 Code Sec. 643(i)(2)(C). 252 Code Sec. 643(i)(2)(D).253 Code Sec. 643(i)(3).254 Code Sec. 643(i)(2)(B) treats a person as a

related person if the relationship between such person would result in a disallow-ance of losses under Code Secs. 267 or 707(b) broadened to include the spouses of members of the family described in such sections.

255 A trust is a foreign trust if it is not a U.S. person under Code Sec. 7701(a)(31)(B). A trust is a U.S. person if (i) a U.S. court is able to exercise primary supervision over the administration of the trust, and (ii) one or more U.S. persons have the authority to control all substantial decisions of the trust. Code Sec. 7701(a)(30)(E).

256 Code Sec. 679(a)(1). This rule does not ap-ply to transfers to trusts established to fund certain deferred compensation plans trusts or to trusts exempt under Code Sec. 501(c)(3).

257 Code Sec. 679(a)(2).258 Code Sec. 679(c)(1).259 Reg. §1.679-2(a)(2)(i).260 Reg. §1.679-2(a)(2)(ii).261 Reg. §1.679-2(a)(4)(i).262 Reg. §1.679-2(a)(4)(ii).263 “Undistributed net income” is defined in

Code Sec. 665(a).264 Code Sec. 679(b).265 Reg. §1.679-2(c)(1).266 A trust is a foreign trust if it is not a U.S.

person under Code Sec. 7701(a)(31)(B). A trust is a U.S. person if (i) a U.S. court is able to exercise primary supervision over the administration of the trust, and (ii) one

or more U.S. persons have the authority to control all substantial decisions of the trust. Code Sec. 7701(a)(30)(E).

267 Code Sec. 679(a)(1). This rule does not ap-ply to transfers to trusts established to fund certain deferred compensation plans trusts or to trusts exempt under Code Sec. 501(c)(3).

268 Code Sec. 679(a)(2).269 Code Sec. 679(c)(1).270 Code Sec. 6048(a). 271 Code Sec. 6048(b)(1).272 Code Secs. 7701(a)(30(E), (31)(B). In addi-

tion, for purposes of Code Sec. 6048, the IRS can classify a trust as foreign if it “has substantial activities or holds substantial property outside the United States.” Code Sec. 6048(d)(2).

273 Code Sec. 6048(a).274 Code Sec. 6048(c).275 Code Sec. 6048(b).276 Code Sec. 6677(a).277 Code Sec. 6677(c).278 Code Sec. 6677(b).279 Code Sec. 6677(a).280 Id. 281 Rev. Proc 2000-12, 2000-1 CB 387.282 Form 945, Annual Return of Withheld Fed-

eral Income Tax, is used to report withheld federal income tax from certain nonpayroll payments, including gambling, IRAs and pensions. Another type of nonpayroll pay-ment is backup withholding. Backup with-holding is required when a Form 1099 is missing a tax ID number.

283 Form 1042—This is the income tax return for reporting the liability for NRA withholding tax, the amounts withheld, the reportable amounts paid to foreign persons and any credit claimed for amounts withheld by other withholding agents. This return is due on March 15 (or the next business day if the 15th falls out on a nonbusiness day) of the following year. All Forms 1042 are required to be filed on a calendar-year basis, and consolidation of separate legal entities for Form 1042 filing purposes is not permitted. For Forms 1042 filed on or before April 15 following the end of the calendar year cov-ered by the form, Form 1042 is considered filed on April 15 for purposes of determining the statute of limitations on assessment. See Code Sec. 6501(b)(2).

284 Form 1042-S—This is an information report-ing form that a withholding agent files with the IRS and issues to each foreign recipient (NRA) of a reportable amount. It shows, among other things, the amount and type of income paid to the recipient, the tax withheld, and any applicable withholding exemption. Form(s) 1042-S should have the same due date as the Form 1042.

285 For further guidance on backup withholding, see Code Sec. 3406 and IRS Publication 1281.

286 IRM §4.10.21.5.

287 Tax ID number with respect to a reportable payment. See Pub. 15 and Pub. 1281 for more information on Form 945.

288 See IRM §25.6.22 and IRS Publication 1035 for more details.

289 Rev. Proc. 2004-59, IRB 2004-42, 678.290 IRM §4.10.21.7.291 IRM §4.10.21.8. 292 IRM §4.10.21.8.1.293 IRM §4.10.21.8.1.1.294 IRM §4.10.21.8.1.2.295 Id.; Form 1042-S instructions for Income,

Exemption and Recipient codes and other application form requirements; Pub. 515 for tax rates.

296 IRM §4.10.21.8.2. 297 IRM §4.10.21.8.2.1.298 Id. 299 Reg. §1.1441-7(b)(1) defines the standards

the withholding agent must apply to deter-mine the correct reporting under Code Secs. 1441–1443.

300 IRM §4.10.21.8.2.1. 301 IRM §4.10.21.8.3. 302 Reg. §1.1441-7(b).303 IRM §4.10.21.8.3.2.304 IRM §4.10.21.8.3.3; see Reg. §1.1441-1(b)

(3) and Code Sec. 1461 for further details. 305 IRM §4.10.21.8.3.3.1.306 Reg. §1.1441-1(b)(3)(iii).307 Reg. §1.1441-1(b)(3)(iii)(A). 308 See Reg. §1.1441-5(d) for more details

on partnerships’ presumption rules. If the partnership is presumed to be foreign, it is not the beneficial owner of the income paid to it. If the partnership is presumed to be domestic, it is a U.S. nonexempt recipient for backup withholding/Form 1099 report-ing purposes. Also, a payment is generally presumed made to a foreign payee if the payment is made outside the United States to an off-shore account and the withhold-ing agent does not have actual knowledge that the payee is a U.S. person. See Reg. §§1.1441-1(b)(3)(iii)(D) and 1.6049(d)(2) and (3).

309 Reg. §1.1441-5(d)(3).310 Reg. §1.1441-1(b)(7)(i).311 Code Sec. 1463. 312 IRM §4.10.21.8.3.4. 313 IRM §4.10.21.8.4.1; Reg. §1.1441-7(b)(4). 314 IRM §4.10.21.8.4.2.315 IRM §4.10.21.8.4.3.316 IRM §4.10.21.8.4.4; Reg. §1.1441-7(b)(5).317 Reg. §1.1441-6(b).318 Reg. §1.1441-1(e)(2)(ii).319 IRM §4.10.21.8.4.4.1 and 2; IRS Publication

515. 320 IRM §4.10.21.8.4.4.3.321 IRM §4.10.21.8.4.5.322 For a more thorough treatment of statisti-

cal sampling audit techniques, see IRM §4.47.3.

323 IRM §4.10.21.8.5.324 IRM §4.10.21.8.6.325 IRM §4.10.21.8.7.

128


326 Reg. §1.1441-3(c)(4)(i)(C).327 Code Sec. 1445(e)(6) and Reg. §1.1445-8.328 IRM §4.10.21.8.7.1.329 IRM §4.10.21.8.7.2. 330 IRM §4.10.21.8.7.3.331 IRM §4.10.21.8.7.4.332 IRM §4.10.21.8.7.5.333 Code Sec. 881(c)(3)(A).334 IRM §4.10.21.8.7.7.335 Rev. Proc. 2000-12, 2000-1 CB 387. 336 IRM §4.10.21.8.7.8; Rev. Proc. 2003-64, IRB

2003-32, 306. 337 IRM §4.10.21.8.7.8.1.338 IRM §4.10.21.8.7.8.2.339 IRM §4.10.21.8.7.8.3.340 IRM §4.10.21.8.7.8.4.341 IRM §4.10.21.8.8.342 IRM §4.10.21.8.8.1; Code Sec. 163(f).343 Reg. §1.871-14(c)(3).344 IRM §4.10.21.8.8.2; Reg. §1.871-14(e).345 IRM §4.10.21.8.8.3.346 IRM §4.10.21.8.9.347 IRM §4.10.21.9.348 IRM §4.10.21.9.1.349 IRM §4.10.21.9.3.350 IRM §4.10.21.9.3.1.351 IRM §4.10.21.9.3.2.352 IRM §4.10.21.9.3.3.353 Reg. §1.1441-4(a)(3).354 Reg. §1.1441-4(a).355 IRM §4.10.21.8.7.6.356 LMSB Control No. LMBS-4-1209-044, im-

pacting IRM 4.51.5 (Jan. 14, 2010).357 Code Secs. 1461 and 6721(a); Greenberg &

Traurig Comments, at 2. 358 Denise Schwieger, Mark Price, Dale Col-

linson and Daniel Mayo, The HIRE Act and the IRS Address Dividend Equivalent Pay-ments on Equity Swaps, KpMg audiT Tax advisory, Apr. 5, 2010 (hereinafter referred to as “KPMG Tax Advisory”).

359 Id. 360 Id., at 3.361 In the event the field examiner examines a

transaction in which the equity security is an equity interest in a publicly traded partner-ship as defined in Code Sec. 7704(c), the field should seek the assistance of counsel.

362 The record date is the “date on which a firm’s books are closed during the process of identifying the owners of a certain class of securities for purposes of transmitting divi-dends … . For example, only the common stockholders who are listed on the record date will receive the dividends that re to be mailed on the payment date.” David L. Scott, Wall sTreeT Words (3rd ed. 2003).

363 A repurchase agreement is a simultaneous agreement (whether written or otherwise) (i) to “sell” an asset, and (ii) to repurchase the same (or substantially similar) asset at the end of a specified period for a set price.

364 Greenberg Traurig Comments, at 3–4. 365 The IDD, however, makes clear that the IRS is

asking about formula pricing and the use of this pricing should be disclosed in response to

this question—Greenberg Traurig Comments, at 6, footnote 24. Also see footnote 23, which provides for Situation 1; “The Model IDR for Withholding Strategy 1” asks financial insti-tutions to identify transactions in which they acquired stock five business days prior to a dividend record date if the financial institu-tion entered into an equity swap within such time frame.

366 Greenberg Traurig Comments, at 4.367 IDD Attachment 6.368 Id.; Greenberg Traurig Comments, at 5. 369 Greenberg Traurig Comments at 5–6. 370 KPMG Tax Advisory, at 4.371 In the event that the field examines a trans-

action in which the equity security is an equity interest in a privately held partner-ship the field should seek the assistance of counsel.

372 IDD—LMSB-4-1209-044, impacting IRM §4.51.5 (Jan. 14, 2010).

373 Tax Management Portfolio 915-2nd, at A-118.

374 Reg. §1.1441-1(b)(7)(iii).375 Tax Management Portfolio 915-2nd, at

A-118.376 Code Sec. 6501(a). Returns that are filed

before the date they are due are deemed filed on the due date; Code Sec. 6501(b)(1) and (2).

377 Code Sec. 6501(e). 378 Id.379 Code Sec. 1295 (b), (f).380 Extenders Act §513; Staff of the Joint Com-

mittee Technical Explanation for the Extend-ers Act, at 153–55.

381 JCT Explanation, at 66; Act Sec. 513 of the Extenders Act; Staff of the Joint Committee Technical Explanation for the Extenders Act, at 153–55.

382 Tim Tuerff, John Keenan, Heather Jurek and Mike Trujillo, Significant changes to statute of limitations under the HIRE Act, deloiTTe uniTed sTaTes Tax alerT, Apr. 16, 2010.

383 These Code sections address: Code Sec. 6038—information reporting with respect to certain foreign corporations; Code Sec. 6038A—information with respect to certain foreign-owned corporations; Code Sec. 6038B—partnerships and notice of certain transfers to foreign persons; Code Sec. 6046—returns as to organization or reorganization of foreign corporations and as to acquisitions of their stock; Code Sec. 6046A—returns as to interests in foreign partnerships; and Code Sec. 6048—informa-tion with respect to certain foreign trusts.

384 These forms address: 5471—information re-turn of U.S. persons with respect to certain for-eign corporations; 5472—information return of a 25-percent foreign-owned U.S. corpora-tion or a foreign corporation engaged in a U.S. trade or business; 926—filing requirement for U. S. transferors of property to a foreign corporation; 8621—return by a shareholder of a passive foreign investment company or

qualified electing fund; 8865—return of U.S. persons with respect to certain foreign part-nerships; and 3520—annual return to report transactions with foreign trusts and receipt of certain foreign gifts.

385 JCT Explanation, at 47.386 T.D. 8850, 2000-1 CB 265 (Jan. 10, 2000).387 Technical Explanation of the Revenue

Provisions Contained in the ‘American Jobs and Closing Tax Loopholes Act of 2010, for Consideration of the Floor of the House of Representatives, prepared by the Staff of the Joint Committee on Taxation (JCX-29-10) (hereinafter referred to as “Tax Loopholes Act Explanation”), at 257.

388 Id.389 Id.390 New Code Sec. 6038D(d).391 Id.392 ACA Comments, at 10. 393 Id., at 10.394 New Code Sec. 6038D(e).395 New Code Sec. 6038D(f).396 New Code Sec. 6038D(g).397 Code Sec. 6663(a). Code Sec. 6663(b)

provides that if the IRS establishes that any portion of the underpayment is attributable to fraud, the entire underpayment of tax shall be treated as attributable to fraud, except for the portion of the underpayment that the taxpayer establishes by a preponderance of the evidence is not attributable to fraud. IRM §9.5.13.2.2.1(1) and (2).

398 Code Sec. 6651(f).399 Id.400 Code Sec. 6651(a)(2); IRM §9.5.13.2.2.4(1).401 Code Sec. 6651(a)(3).402 Code Sec. 7203.403 Code Sec. 6651(a)(1); IRM §9.5.13.2.2.3(1).404 Del Commercial Properties, Inc., CA-DC,

2001-2 usTc ¶50,474, 251 F3d 210 (2001), cert. denied, 122 SCt 903 (2002).

405 The information reporting requirements identified under Code Secs. 6038, 6038A, 6038D, 6046A and 6048.

406 New Code Sec. 6038D(d).407 Code Sec. 6038.408 Code Sec. 6038B. 409 Code Sec. 6046.410 Code Sec. 6046A.411 Code Sec. 6048.412 Code Sec. 6662, as amended by Section 512

of the new law.413 Code Sec. 6662(c); IRM §9.5.13.2.2.2(2).414 Code Sec. 6662(d)(1)(A).415 Code Sec. 6662(d)(1)(B).416 IRM §9.5.13.2.2.2(1).417 Code Sec. 6672; IRM §9.13.2.2.5(1).418 Code Sec. 6694(a)(1); Notice 2009-5, IRB

2009-3, 309.419 Code Sec. 6694(a)(3).420 Code Sec. 6694(a)(2).421 Notice 2009-5. In the case of a tax return

preparer, however, a written determination with a misstatement or omission of material fact is substantial authority unless the tax


September 2010

return preparer knew or should have known of the misstatement or omission of material fact when the return or claim for refund was filed. The applicability of court cases to the taxpayer’s situation by reason of the taxpayer’s residence in a particular jurisdiction is not taken into account in determining whether there is substantial authority for a position in accordance with Reg. §1.6662-4(d)(3)(iv)(B). Notwithstanding the preceding sentence, there is substantial authority for a position if the position is supported by controlling prec-edent of a U.S. Court of Appeals to which the taxpayer has a right of appeal with respect to the position. Finally, there is substantial au-thority for a position only if there is substantial authority on the date the return or claim for refund is deemed prepared, as prescribed by Reg. §1.6694-1(a)(2), or there was sub-stantial authority on the last day of the tax year to which the return relates. Conclusions reached in treatises, legal periodicals, legal opinions or opinions rendered by tax profes-sionals (including tax return preparers) are not authority. The authorities underlying such expressions of opinion, if applicable to the facts of a particular case, however, may give rise to substantial authority for the position. Solely for purposes of Code Sec. 6694(a), a tax return preparer nevertheless will be considered to have met the standard in Code Sec. 6694(a)(2)(A) if the tax return preparer relies in good faith and without verification on the advice of another advisor, another tax return preparer or other party. Factors used in evaluating a tax return preparer’s good faith reliance on the advice of another are found in Reg. §1.6694-2(e)(5).

422 Code Sec. 6656.423 Id.; Rev. Proc. 90-58, 1990-2 CB 642, am-

plified and clarified by Rev. Proc. 91-52, 1991-2 CB 781, which provides guidance as to how federal tax deposits will be credited for purposes of Code Sec. 6656.

424 Code Sec. 7206(1).425 Code Sec. 7202. 426 Code Sec. 7201. In addition, the defendant

may have to pay the costs of prosecution.427 Corporations and other organizations can

be held liable for the criminal acts of their directors, employees or agents. In June 1999, the U.S. Department of Justice created an additional incentive for corporations to implement robust compliance programs when it instructed federal prosecutors to

consider the existence of an organization’s compliance programs in determining to charge an organization for the misconduct of its employees or agents. See u.s. aTTorney’s Manual, Principles of Federal Prosecution of Business Organizations, §9-28.800 (2008). The Sentencing Commission in response to a directive in the Sarbanes-Oxley Act un-dertook a major revision to the definition of an effective compliance program and how it would impact a corporation’s sentence under the Sentencing Guidelines. These revisions reflected the public’s reaction to the corporate frauds that had dominated the news and now require a corporation‘s board of directors to be knowledgeable about the content and operations of any compliance and ethics program and to maintain reasonable over-sight with respect to the implementation and effectiveness of the program. In addition, the person assigned day-to-day operations of a compliance and ethics program was required to report directly to the board or an appropri-ate subcommittee of the board. In order for a compliance program to qualify for a sentence reduction, there must be an effective program to prevent and detect violations. According to the Sentencing Guidelines, an effective compliance program “shall be reasonably designed, implemented and enforced so that the program is generally effective in preventing and detecting criminal conduct.” See USSG §8B2.1(a)(2). See also Jeffery M. Cross and Marc H. Kallish, The Definition of an Effective Compliance Program Under the Sentencing Guidelines: A Template for Use Beyond the Guidelines, Corporate Compli-ance and Ethics Institute 2009, Practising Law Institute Course Handbook Series Number B-1731 (2009); and Rebecca Walker, The Evolution of the Law of Corporate Compli-ance in the United States: A Brief Overview, Corporate Compliance and Ethics Institute 2009, Practising Law Institute Course Hand-book Series Number B-1731 (2009); and Corporate Compliance and Ethics Institute 2009, Practising Law Institute.

428 The Qualified Intermediary, or QI, program was intended to put the burden of informa-tion reporting and withholding tax returns on the foreign financial institutions that were presumably closer to their customers under KYC principles. The theory being that the foreign financial institutions would not only be in the best position to collect the

required documentation (e.g., Forms W-8s, W-8BENs, W-8IMYs or W-9s), but would also be able to verify that such information about their clients was correct. The QI would agree to assume responsibility for obtaining docu-mentation from its customers covered by the QI agreement with the IRS and to substanti-ate the status of its customers as the benefi-cial owners of such income. However, in a telling exception, the QI rules under current law continue to treat a foreign corporation as such for U.S. tax purposes, even though it was beneficially owned by U.S. persons (absent actual knowledge that the beneficial owners were U.S. persons). This would hold true even though the foreign corporation was located in a tax haven. Under the QI regu-lations, the foreign financial institution or clearing house (or foreign branch or office of a U.S. financial institution or clearing house) would enter into a contract with the IRS, agree to verify the identities and beneficial ownership of its customers (and generally not look beyond the customers’ foreign entities in which they had an ownership interest) and be subject to an annual audit by an external auditor. Unless the QI had agreed to assume the U.S. withholding responsibilities, which was atypical, it would certify to the U.S. withholding agent or payor as to the amount of withholding (or reduced treaty rate) by providing withholding rate pool informa-tion as to the portion of each payment that qualifies for exemption or a reduced rate of withholding. Thus, identifying customer information was effectively shielded from both the IRS, as well as the U.S. withhold-ing agent with respect to foreign persons, although the QI was generally required to provide Form W-9s to the withholding agent so that it could provide 1099s to its U.S. customers. See Reg. §1.1441-1(e)(5); Announcement 2000-48, 2000-1 CB 1243; Reg. §1.1441-1(e)(5)(ii); Rev. Proc, 2000-12, 2000-1 CB 387, supplemented by Announcement 2000-50, 2000-1 CB 998, and modified by Rev. Proc. 2003-64, 2003-2 CB 306; Rev. Proc. 2005-77, 2005-2 CB 1176; Rev. Proc. 2002-55, IRB 2002-35, 435; Rev. Proc. 2000-55, IRB 2002-36, 481; Rev. Proc. 2002-35, IRB 2002-2, 1187. T.D. 8881 (May 16, 2000).

429 Jaclyn Jaeger, IRS Spotlights Cross-Border Withholding Tax, coMpliance WeeK, Apr. 6, 2010.

This article is reprinted with the publisher’s permission from the Taxes–The Tax Magazine, a monthly journal published by CCH, a Wolters Kluwer business.

Copying or distribution without the publisher’s permission is prohibited. To subscribe to the Taxes–The Tax Magazine® or other CCH Journals please call

800-449-8114 or visit www.CCHGroup.com. All views expressed in the articles and columns are those of the author and not necessarily those of CCH.

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